So if the share price is $10 and shareholders’ equity is $5, investors are ready to pay two times the book value. In an efficient market, the share price should reflect a firm’s future value creation potential whereas the accounting or book value of equity reflects the accumulation of past share issues and past retained profits/earnings, i.e. not yet distributed in dividends.
A higher p/b ratio should reflect greater expected future gains because of perceived growth opportunities and/or some competitive advantages and/or lesser risk but at the same time it indicates that the share price is relatively more expensive.
During periods where markets are out of equilibrium, for example during a bubble, high p/b ratios may also reflect over-optimism and over-pricing. Conversely, a lower p/b ratio can reflect either poorer future opportunities or potentially a bargain if the market is over-pessimistic or if one believes the market is not taking into account potential restructuring or a takeover that would improve future prospects.
A p/b greater than one means the market value of the company is greater than its book value, this difference is sometimes called the market value added or market goodwill. It is because accounting poorly reflects the internally generated intangible assets of new economy firms, they generally have higher p/b ratios than the more traditional ‘bricks and mortar’ type firms that have more tangible assets sitting on their balance sheet.
The p/b ratio, like other pricing ratios such as the price/earnings, price/sales or price/cash flows, is often used in valuing firms or takeover targets by finding the p/b ratio of a set of comparable companies and applying it to the target’s current or forecasted book value. Sometimes, investors look at the inverse of the ratio, the book/price or book-to-market ratio.