Book-to-market ratio definition

What is the book-to-market ratio?

The book-to-market ratio assesses a company’s value by comparing its book value to its market value. The book value is the value of a company on paper according to its common shareholder equity, while the market value of a company is determined by its market capitalisation.

Common shareholder equity refers to the net value of a company. It represents the amount that would be returned to shareholders if the entirety of a company’s assets were sold off and its debts were repaid in full. Companies will include the shareholder equity on their balance sheet.

Market capitalisation is the total market value of a company’s outstanding shares. It can be calculated by multiplying the current stock price by the total number of shares issued.

Book-to-market ratio formula

To calculate the book-to-market ratio you would divide the common shareholder equity by the current market capitalisation. The book-to-market ratio formula is as follows:

What does the book-to-market ratio tell traders?

The book-to-market ratio is used by traders as an indicator of whether a company’s stock is currently under or overvalued. Overvalued shares will have a higher market value than book value, and undervalued shares will have a lower market value than book value.

Generally speaking, if a stock’s book-to-market ratio is above one, it is believed to be undervalued because it indicates that the company’s stock is trading for less than the total value of its assets. And if it is below one, the stock is considered overvalued as it indicates that a company’s stock is trading for more than the total value of its assets.

Example of a book-to-market ratio

For the purpose of this example, let’s assume that company A has a common shareholder equity of $5 billion, and a market capitalisation of $1.5 billion. To calculate the book-to-market ratio for company A, we would divide $5 billion by $1.5 billion, which would give a figure of 3.33. Since this is above one, it might indicate that company A’s stock is currently undervalued.

On the other hand, let’s look at company B, which has a common shareholder equity of $7 billion, and a market capitalisation of $45 billion. If we did the same calculation, dividing the shareholder equity of $7 billion by the market capitalisation of $45 billion, we would get a book-to-market ratio of 0.15. This would indicate that this company’s stock is currently overvalued.

Book-to-market ratio vs price-to-book ratio

The price-to-book ratio is the opposite to the book-to-market ratio, and rather than dividing the common shareholder equity by market capitalisation, price-to-book divides the market capitalisation by the common shareholder equity.

In doing so, the price-to-book ratio seeks to assess whether a stock is undervalued or overvalued but by opposite metrics to the book-to-market ratio. A value of less than one in the price-to-book ratio indicates that a stock is undervalued, while a value of more than one in the price-to-book ratio indicates that a stock is overvalued.