Book value doesn't always mean what it seems to.

How much should you pay for a stock? There are nearly as many answers to that question as there are people buying stocks.

Some will tell you a stock's price should be tied to its earnings (the P/E ratio). Others sing the praises of price to sales (the P/S ratio). But Benjamin Graham, the "father of value investing," argued that investors are best advised to use a combination of approaches. For example, one might buy stocks that sell for P/E ratios of less than 15, but only when their prices are also less than 1.5 times their book value (a 1.5 P/B ratio).

Just about everyone has heard of the P/E ratio. But what is a P/B ratio, and how do you figure it out?

The short answer is that you can find a stock's P/E and P/B ratios -- and its P/S ratio, too, for that matter -- by looking the stock up here on Fool.com and clicking on its "Stats" tab -- here's Hewlett-Packard's stats page, for example.

The long answer
For those looking to learn more about this metric, the longer answer is that you calculate a stock's P/B thus:

P/B ratio = market capitalization / book value of equity

If that looks like nonsense to you, let's break it down further:

  • Market capitalization = shares outstanding x share price
  • Book value of equity = book value of assets - book value of liabilities
  • Therefore the P/B ratio is = market cap / (BV of assets-BV of liabilities)

Now that I've got it, what do I do with it?
The upshot of all that math is this: A stock's "book value" is the value of its assets (its cash, accounts receivable, real estate, and so on) minus its liabilities (its debts, accounts payable, and other financial obligations). And the stock's P/B ratio is the difference between how much the stock costs on the stock market and its book value.

Generally speaking, if the P/B is greater than 1.0, the stock costs more than the business it represents. Conversely, if a stock sells for a P/B of less than 1.0, then you can buy the stock for less than what it would cost to rebuild the company from the ground up.

It's not the final word
So should you ever buy a stock where the book value is greater than 1.0? The answer is yes, for a number of reasons:

  • Stocks rarely sell for a P/B ratio of less than 1.0. A quick scan of the markets through Finviz.com's stock screener reveals that, out of nearly 7,000 listed stocks on the market, barely one-in-seven carry a P/B ratio of less than 1.0. If you bought only stocks that meet this criterion, you'd be ignoring 85% of the market -- which includes some great companies.
  • Book value may not mean what you think it does. If a company's assets have a long service life (e.g., buildings, factories, land), accountants may have depreciated their value over time to near-zero on the balance sheet -- even though the assets still have years of useful life (and value) ahead of them. Or a long-lived asset may simply be assigned the book value of the price paid to acquire it. Land, for example, is usually "booked" at its purchase price, despite the fact that land generally appreciates in value over time. In an extreme case, like tree farm Plum Creek Timber (UNKNOWN:PCL.DL), trees grow, so their real value moves in an opposite direction of depreciation.
  • Some assets are hard to value. Other companies (such as tech firm Microsoft (NASDAQ:MSFT)) may have most of their value tied up in intangible intellectual property, which is tough to quantify on a balance sheet. This may prevent it from showing up as accurate "book value," making the stock's P/B ratio look higher than it perhaps should.

In short, a "high" P/B ratio isn't always bad. But by the same token, a low book value isn't always good, either.

The trouble with a low P/B ratio
In a nutshell, the problem with assuming that a low P/B ratio signals a "cheap stock" is this: If the book value is inflated, your money isn't buying as much as you think. This could be the situation if, for example:

  • Your target company loves to buy other companies. Let's use Microsoft as an example again. Over the past three decades, Microsoft has made well over 100 acquisitions of other companies -- often at high prices -- including aQuantive ($6.3 billion), Nokia ($7.2 billion), and Skype ($8.5 billion). Some of these acquisitions are working out. Others aren't. But all had to be recorded on the company's balance sheet at the price Microsoft paid for them. If it overpaid for money-losing technology, then that book value may not be worth what it seems. 
  • Time changes things. Ultimately, a company that overpaid to acquire another company may be forced to confess its mistake in future years, taking a "charge to earnings" and writing down the book value of the acquisition. When that happens, hundreds of millions of dollars worth of book value that you thought the company had simply...vanishes. And the low P/B ratio that first attracted you? That skyrockets. 

Rule No. 1: Use common sense
When you think about it, this is all common sense. If a company has a high P/B ratio, but people continue to happily pay that price on the stock market, there's probably a reason -- e.g., there may be value in the company that doesn't show up as book value.

Conversely, if anyone could look at a company with a low P/B ratio and know with 100% certainty that it was "cheap," then everyone would do that. They'd buy the cheap stock, bid against each other to own it, and drive the price up to a P/B ratio of 1.0.

Presto chango, the stock would not be cheap anymore.

So how should you use the P/B ratio? When you get right down to it, you should use it just as Benjamin Graham advised: As one tool to be used alongside other tools, such as P/S and P/E. Discovering a stock with a low P/B ratio is only the start of your process of evaluating whether that stock is a bargain.

Don't let it be the end, too.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.