Does a High Price-to-Book Ratio Correlate to ROE?

Price-to-book (P/B) is an equity valuation ratio that compares market value (stock price per share) to book value (equity of shareholders). P/B is expressed as a multiple—how many times book value stock investors are willing to pay to acquire a company's stock. Book value is a calculation of the company's recorded assets, minus the liabilities shown on its balance sheet—a per-share estimate of the liquidation value of the company.

How a High P/B Ratio Correlates to High ROE

A high P/B ratio doesn't necessarily correspond to a high return on equity (ROE), but it does under ideal circumstances. Investors favor companies that offer better returns on equity; as a result, this favor translates into higher company prices. Understandably, a low P/B ratio often correlates to an undesirable ROE and return on assets (ROA).

The straightforward calculation of P/B is as follows:

The per-share equity figure is arrived at by looking at the company's most recent balance sheet and dividing shareholders' equity by the number of outstanding shares.

Meanwhile, ROE is a metric of profit efficiency, an equity valuation that measures profitability as a function of the amount of capital invested by stockholders. This metric provides a percentage assessment of the return on that equity investment.

ROE is expressed as a percentage and is calculated as follows:

It's useful to consider P/B ratio evaluation along with ROE evaluation as they both factor in the book value of equity. Neither valuation tool is flawless, so it's helpful to check one valuation against another. P/B and ROE evaluate a stock from different viewpoints, but they are related; they both factor in the book value of equity.

What to Watch for in the Data

A high P/B ratio stock commonly has a correspondingly high ROE since investors are inclined to pay higher multiples of book value for a stock that is showing them a good return. Companies with high growth rates are likely to have high P/B ratios. IBM serves as a great case study showing the effects of ROE on P/B ratios. In 1983, it had an ROE of 25%, and its stock traded at three times its book value. In 1992, it traded at book value due to its decreased ROE to negative values.

Any sizable divergence between the two measures—for example, a high P/B with a low ROE—can be a warning signal that shareholder equity is no longer increasing. This contrasting position between ROE and P/B indicates that the securities are overvalued. Alternatively, a low P/B with a high ROE indicates that the securities are undervalued.

A wise approach for evaluating may be to combine the measures instead, such as P/B and ROE, to examine trends of the figures over the years.