The top-down analysis begins with a “broad lens” analysis. It takes into account the detailed analysis of the financial environment for the selection of stocks. Once the stocks are identified and strategically positioned to benefit from the worldwide economic trends, an analyst focuses on the actual figures and balance sheets of this stock category to make a final investment decision.
Investors using the top-down approach begin the analysis with the evaluation of the global economic trend. Then they analyze macro trends in economies, which they consider have massive potential. Analysts’ next concern is to evaluate the sectors equipped to take advantage of certain macro patterns. Lastly, the stocks within favorable sectors are selected.
A lot of financial metrics available for the analysis and making decisions about the selection of stock. One of them is to evaluate how well the underlying business is performing in the market. At the same time, it is crucial to consider whether the price of the stock makes sense. If the stock price is too high, it is said that the stock is overstated and ready for a fall, and an investor would eventually lose money. On the other side, if the stock is undervalued or priced too low, it might make a fortune.
But,how do you say that? Well, one way is to see the price/book ratio of a business, also named as P/B ratio in short. It is a fast metric that estimates a share’s market price and can be used in a similar environment to compare it with others. The P/B ratio will indicate whether or not the per-share price is fair, is lower, or is high.
Let’s have a closer look at the price-to-book ratio and how you can use this ratio and evaluate stocks to maximize your investments and produce profitable returns.
What is a Price-To-Book Ratio?
To evaluate the market capitalization to its book value, investors use the price-to-book ratio (P/B ratio). The P/B ratio is a financial ratio often used to compare the current share price to the firm’s book value. It is determined by dividing the company’s stock price per share by its book value per share. An asset’s book value is equal to its balance sheet carrying value, and firms determine it by netting the asset against its cumulative depreciation.
The book value is also the company’s tangible net asset value, measured as total assets minus intangible assets and liabilities (i.e., patents, goodwill). Book value can be net or gross expenses, such as sales taxes, service charges, and trade costs for the initial investment outlay. This ratio may be known to some people by its least familiar term, the price-to-equity ratioand market-to-book ratio.
The price-to-book ratio reflects the company’s stock share price with relevance to its book value per share. Book value refers to an entity’s inherent economic value, precisely comparing all its assets and all its expenditures and liabilities.
What is a Good Price-to-Book Ratio?
According to some analysts, a P/B ratio of under 1 means that a stock is underestimated. A 1 ratio may mean that stock is “fair” priced; however, where the market value corresponds to the company’s book value. However, a P/B ratio of 3 or more signals that a market value is too high and might ready for a fall.
Key Notes:
- The P/B ratio is a financial ratio often used to compare the current share price to the firm’s book value.
- P/B ratios below 1 are considered beneficial investments.
- The P/B ratio calculates a company’s book value for the market.
- P/B ratio is a financial metric for recognizing future investments by value investors.
- Price-to -Book Ratio is also named as Price-to-Equity Ratio and Market-to-Book Ratio.
How to Calculate Price-to-Book Ratio?
Price-to-Book Ratio can be calculated in two ways, but both methods must produce the same results. The calculation can be performed in two ways, but either way is the same. Firstly, the company’s stock price should be separated from its balance sheet by its overall book value. The second option is to divide the company’s current share price by the book value per share (BVPS).
Let’s have a quick look on the formula used to calculate the Price-to-Book Ratio:
Price-to-Book Ratio or P/B Ratio = Price / Bookings
However, Book Value per Share is calculated by:
The market value per share is derived by having looked at the market quoted share price.
How will the P/B ratio be used to analyze stocks?
Using the P/B ratio as a financial metric for stock analysis indicates whether an investor pays too much for what would be left if the firm suddenly went bankrupt. The book value is generally measured for businesses in distress without intangible assets with little resale value.
Most banks’ financial assets and liabilities are valued at market prices; this is why P/B ratios are widely used to analyze banks’ stocks. A higher P/B ratio means that investors expect management to produce more profit from available resources or a set of assets.
As explained above, a firm’s P/B ratio can be determined just as simple as a mathematical trick. Although this may sound like doing some math, it could be tricky and complicated to find P/B ratios for multiple businesses when an investor or analyst is searching for investment opportunities.
So that’s why we’re going to use a magical platform to help us with our analysis called TradingLever. It is an interactive platform for extensive and systematic top-down analysis. It is a handy platform for analyzing stocks using multiples financial metrics (also provided on the website) before making a profitable investment decision.
Example:
As the P/B ratio is more suitable for analyzing banks and financial consultancy firms’ stocks, that’s why we will use the financial services industry in our example:
In global capital markets, COVID-19 has created considerable uncertainty and high volatility. In part of the study on Global Banking M&A Outlook H2 2020, the discussion is made on the areas, most likely to be affected by the overall banking industry, including valuation and profitability. Investors are eager to analyze whether it is profitable to make investments in the banking sector right now.To perform this analysis we need to use a stock analyzer. In this article we will use the TradingLever stock analyzer to perform top-down analysis for the banking industry.
Let’s begin the analysis:
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Let’s look at the table and stock charts in image 1; we can see that many Tabs are available, including, Sector, Industry, market cap, and financial metrics tab. On the right side, there is a graphical representation of data to present the analysis more clearly.
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In Image 2, you can see that we have selected a financial metric used to analyze the stock. As we are working with a P/B ratio, we selected it.
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Look at image 3; we can see that the P/B ratio information is available for all sectors. As we are concerned with the Financial Sector, so we have opened and expand the Finance Tab. This also updats the stock graphs. And here we can easily see that several tabs are available here. This will provide us the P/B ratios for all the financial sector businesses.
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Let’s glance at image 4; we can see the “Major Banks” Tab is present there. Five sections are available from which we can choose for further analysis. These are Mega-Cap, Large-cap, Small-cap, Mid-cap, and Micro-cap. However, we select the Mega-Cap, as banks in this section have the maximum return potential.
As we know that Mega-cap stocks are companies with more than $200 billion in market capitalization, this is why there are two banks available. These are JPMorgan Chase & Co and Bank of America Corporation (BAC).So, now we can compare the P/B ratios for both stocks and make decisions that result in an attractive return.
Conclusion:
In conclusion, the price-to-book ratio for investors is a beneficial financial ratio. A P/B ratio is an essential tool that investors use for top-down analysis. However, it might not always be easy to determine a good P/B ratio. But the P/B ratio is just one way of measuring a stock at the end of the day.
As Tadesse says, there’s a lot of data out there to consider — a veritable “zoo of valuation ratios.”
It is advisable to use the P/B ratio in conjunction with profitability metrics such as return on equity to get a clear picture of a company’s value. For instance, the price-to-book ratio multiple of Bank of America has been lower than JP Morgan Chase’s for the last five years. That does not necessarily mean that Bank of America is “cheaper.” The ROE of JP Morgan has been consistently higher than that of Bank of America.
To perform such analysis, it is customary o use a stock analyzer such as Trading Lever. Trading Lever is also a free stock charting software that allows anyone to make stock charts for any stock and any stock aggregate, as defined by the user.
