Why Use Book To Market And Not Price To Book? by Tim du Toit, Quant Investing
Why do think we recommend that you use the book to market ratio, and not price to book when screening for undervalued companies?
A question we get a lot
If you don’t know you are not the only one - it is a question we have had from a lot of screener subscribers.
The simple answer - book to market gives you better results.
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That is also the reason why you see that all academic research studies use the book to market ratio.
Let me explain.
How it’s calculated
The price to book ratio is calculated as - Market value / Book value (or Share price / Book value per share).
The book to market ratio is calculated as - Book value / Market value (or Book value per share / Share price).
Simply the inverse
As you see the ratios are very similar, the one is simply the inverse (the opposite) of the other.
But why does the book to market value give you better results, you may be thinking?
Negative book value
The simple answer - negative book value.
If you used the price to book ratio, the lower the value is more undervalued the company is.
But if the company's book value is negative it will make the price to book value negative.
Now if you look for companies with the lowest price to book value (most undervalued companies) those with a negative price to book value will be the first on your list.
Not what you are looking for
And this may not be the companies you are looking for.
The book to market ratio on the other hand works just the other way around. The higher the book to market value of company is the more undervalued the company is.
Negative book value does not matter
With the book to market ratio it does not matter if a company has a negative book value.
This is because, to find undervalued companies, you are looking for companies with the highest book to market value.
If the book value of the company's negative it will have a negative book to market value and the company will not show up in your results.
This is what you are looking for.
Why negative book value?
Why do companies have a negative book value?
The most obvious reason I have seen is because they wrote off a large amount of goodwill and the resulting loss wiped out the book value of the company.
I'm sure you can also think of a few other reasons.
How to screen
In the screener when looking for companies that are undervalued in terms of price to book value use the book to market value ratio instead as your primary factor.
If you set the slider from 0 to 20% (as shown above) we have already programmed it for you so that it will give you a list the most undervalued companies.
If you prefer price to book
If you prefer to see your results as price to book value simply select price to book as one of your output columns.
You can then sort this column from low (the most undervalued companies) to high.
Give the book to market ratio a try, it will give you better screening results.
Wishing you profitable investing
Tim du Toit