Why do 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 alone, it is a question asked by a lot of our stock screener subscribers.
The simple answer - book to market gives you better results.
That is why I am sure you also noticed that all academic research studies uses the book to market ratio and not price to book.
Let me explain.
How it’s calculated
The price to book ratio is calculated as - Market value / Book value (or the stock price / Book value per share).
The book to market ratio is calculated as - Book value / Market value (or Book value per share / Stock price).
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?
Negative book value
The answer - negative book value.
If you use the price to book ratio, the lower the ratio the 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
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 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.
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 of the most undervalued companies.
And this is what you are looking for.
Why negative book value?
Why do companies have a negative book value?
One reason is because they wrote off a large amount of goodwill and the resulting loss wiped out the book value of the company. Or the total losses so far is more than its equity.
I'm sure you can think of a few other reasons.
How to screen
In the Quant Investing stock 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 book to market 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 and better investment ideas.
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PPS Why not sign up right now while it's still fresh in your mind