The basic idea of value investing is to find stocks whose market prices are relatively low compared to the value of the underlying firms. Value investors often rely on ratios which compare the market price with a measure of underlying value.

One such popular measure is the P/E ratio which looks at the ratio of price to earnings. In this article we look at the P/BV ratio or price to book value which is another key tool for digging out undervalued stocks.

What is price to book value or the P/BV ratio?

P/BV is simply the market price per share divided by the book value of equity per share. The market price is straightforward but the concept of book value of equity requires further explanation.

It is based on the balance sheet of a company and is the difference between its assets (what it owns) and liabilities (what it owes).

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Another way of thinking about the book value of equity is that it is the firm's proceeds when it first issued equity plus earnings since then (minus losses) and minus the dividends paid out over its life.

P/BV = (Equity + Earnings � Losses) � Dividend.

Why is P/BV a good measure of value?

Traditionally stocks with a P/BV significantly less than 1 are considered good buys.

The argument is that balance sheets are sometimes a better measure of a company's value than market prices which are often volatile and guided by sentiment.

Therefore firms which trade below their book value will sometimes be good firms which are being undervalued by fickle markets.

Another argument is that the book value of a company is a good estimate of its liquidation value: that is, the money left over after selling its assets and paying off its liabilities. Therefore a firm that trades below book value is likely to be a good buy.

There is a fair amount of evidence from around the world that low P/BV stocks do earn a higher return in the long run.

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A study based on US stock returns between 1973 and 1984 found that stock with low P/BV earned a significantly higher return than the market. There have been similar results from studies in Japan [Images], Europe and emerging economies like South Korea.

Are there any shortcomings to PBV as a stock guide?

Yes, as always in investing there are no silver bullets which will make you money all the time.

For one thing, accounting measures never give you the full picture. They are generally based on the historical cost of assets rather than their current market price.

Also balance sheets don't give you accurate estimates of intangible assets like brands and research and development.

This means in particular that P/BV isn't a good measure for certain sectors like consumer goods and IT with lots of intangible assets. For example, the book value of Infosys [Get Quote] will not factor in the intangible value of Infosys as a global brand.

Such companies can have high P/BV ratios and still be good buys.

There is also some evidence that low P/BV stocks carry higher risk and in particular may have more debt which increases the chance of bankruptcy.

Some tips to use P/BV effectively

P/BV is most relevant to 'old economy' industries with a high proportion of tangible assets like automobiles, engineering, capital goods and banks. Avoid using it for sunrise industries like IT and biotech.

• How to pick the right shares

As always with ratio analysis you need to look at trends over a number of years and benchmark the company with other stocks in its own industry.

Don't use P/BV alone but combine it with other ratios like P/E and return on equity as well as a general analysis of the company's management and strategy. Avoid companies which are heavily in debt.

Conclusion

P/BV isn't a magic formula but combined with other ratios and good fundamental analysis it can help you identify under valued stocks which will earn higher returns in the future