Book-to-Market RatioDefined along with formula and more

Generating profits is the primary purpose of running a business.

If you’re someone who frequent my write-ups, you may already be familiar with this phrase by now.

But aside from that, a business would want to increase its value.

It can achieve this in many ways such as performing positively for consecutive periods, always getting high customer ratings, or offering products or services that no other business can.

A business that is viewed positively by external parties will usually be valued highly.

We refer to this value that is determined by external parties as the market value of the business.

But that’s not the only way to measure the value of the business though.

A business’s value can also be determined by its historical figures.

I’m particularly referring to its books and balance sheet.

The difference between the total assets and total liabilities is a business’s book value.

Sometimes, along with total liabilities, the total preferred shares figure is also deducted from the total assets to determine the book value of the business.

In both cases, the data needed for the computation of book value can be found on the business’s balance sheet (or books).

Analysts compare these two valuations to come up with two ratios: the market-to-book ratio (a.k.a. price-to-book ratio) and the book-to-market ratio.

Most investors are more familiar with the market-to-book ratio, but we’re not here to discuss that.

Instead, in this article, we will be focusing on the book-to-market ratio.

We will learn its definition, as well as the formula to calculate it.

We will also be learning how it could be significant for your business

What is Book-to-Market Ratio?

 

The book-to-market ratio is a financial metric that compares a business’s book value to its market value.

The book value of a business represents its historical or accounting value, which you can find on its balance sheet.

It could be the difference between the total assets and total liabilities (or shareholder’s equity).

Sometimes, it’s the book value of common shareholders’ equity.  

On the other hand, the market value of a business refers to how the market values the business’s stocks.

It is derived from the business’s market capitalization, which is the total market value of all outstanding shares.

To compute it, we only need to multiply the price of one share by the number of outstanding shares.

The book-to-market ratio compares these two valuations, specifically dividing the book value of the business by its market value.

The result is a ratio that determines whether a business is overvalued or undervalued.

We can also look at it to determine whether a business’s stocks are overvalued or undervalued.

Book-to-Market Ratio Formula

Computing the book-to-market ratio is fairly simple.

It only involves two variables, which are the book value and the market value of the business.

To compute the book-to-market ratio, we only have to divide the book value of the business by its market value.

Put into formula form, it should look like this:

Book-to-Market Ratio = Book Value of the Business ÷ Market Value of the Business

-or-

Book-to-Market Ratio = Common Shareholders’ Equity ÷ Market Capitalization

The book value of a business can come in two forms.

It could simply be the difference between the business’s total assets and total liabilities, or it could be the book value of the common shareholders’ equity.

As for market capitalization, it involves the market value of the business’s share and the number of outstanding shares in the market.

To calculate market capitalization, we only need to multiply the market value of one share by the total number of outstanding shares.

To make the formula more understandable, let’s have a short example.

Suppose we gather the following data:

• Common Shareholders’ Equity – $680,000
• Market Value of One Share – $8.50
• Number of Outstanding Shares – 100,000

First, let’s compute the market capitalization:

Market Capitalization = Market Value of Share X Number of Outstanding Shares

= $8.50 x 100,000

= $850,000

Now that we have all the variables we need, we can proceed with the computation of the book-to-market ratio:

Book-to-Market Ratio = Common Shareholders’ Equity ÷ Market Capitalization

= $680,000 ÷ $850,000

= 0.80

As per computation, the book-to-market ratio is 0.80. What does it mean though?

What Does the Book-to-Market Ratio Tell Us?

The book-to-market ratio can tell us whether a business is overvalued or undervalued.

Overvalued is a state in which the business’s shares are trading for more than their book value.

On the other, being undervalued is the opposite – it is when the business’s share are trading for less than their book value.

Depending on the book-to-market ratio figure, we can assess whether a business is in either of the two states.

If a business’s book-to-market ratio is exactly 1, then its book value is equal to its market value.

It is neither overvalued nor undervalued.

The market values the business the same amount as its accounting value.

If a business’s book-to-market ratio is higher than 1, it means that the business is undervalued.

Particularly, its shares are selling for less than their book value.

Is it a bad thing though?

Well, not for value managers who interpret it as the business being a value stock.

This means that it’s cheap to purchase a share of the business, but you’ll be getting its value.

For the business itself though, it’s not a really attractive position.

A business would want its shares to sell at least the same price as their par value.

If a business’s book-to-market ratio is lower than 1, it means that the business is overvalued.

This means that its shares are selling for more than their book value.

It implies that investors are willing to pay more because the returns are worth it.

Basically, they are willing to pay a premium because of the business’s high potential to create high returns in the future.

Businesses that are not asset-heavy, such as those within the service industry, tend to have low book-to-market ratios.

Book-to-Market Ratio vs Market-to Book Ratio

The market-to-book ratio (a.k.a. price-to-book ratio) is basically the reverse of the book-to-market ratio.

To compute it, you divide the market value of the business by its book value, which is the reverse of the book-to-market ratio formula.

Just like the book-to-market ratio, the market-to-book ratio tells us whether a business is overvalued or undervalued.

If the market-to-book ratio is lower than 1, it means that the business is undervalued.

This means that the business’s shares are selling for less than their book value.

It signifies to investors that it’s cheaper to purchase a share of the business, but it could be a double-edged sword.

A low market-to-book ratio may indicate that the business is facing financial issues.

Usually, a business’s stock will sell for less than its book value when it’s not performing as well as expected.

On the other hand, if the market-to-book ratio is higher than 1, it means that the business is overvalued.

This means that investors are willing to pay more than the book value of the business’s shares.

A business that has a high market-to-book ratio is usually performing well.

It also usually has great potential to bring huge returns in the future.