A book-to-market ratio is a mathematical comparison of a company's actual value to its market value. The actual value of a company is determined by internal accounting, and its market value is its market capitalization. Generally, the result of this comparison can be used by market analysts to determine if a company is overvalued or undervalued. Analysts can then evaluate the company's common stock as a potential investment, which will often result in public upgrades or downgrades of that stock.
Calculating a book-to-market ratio is done by dividing the company's book value by its market value. The book value must be obtained from the company and can usually be derived from the earnings announcements that most companies perform every three months. Generally, the market value is equal to the company's market capitalization, which can be calculated by multiplying the price of its stock by the total shares of stock that it has issued.
A book-to-market ratio greater than one indicates that the company may be undervalued and many investors will take this as a sign that it is a good investment. This is because obtaining a ratio greater than one requires the book value to exceed the market value, which may indicate that investors have not given the company the credit it deserves. Similarly, a book-to-market ratio less than one indicates that the company may be overvalued, and many investors will take this as a sign that it may be time to cash in their shares of stock. The reasoning here is that for the ratio to be less than one, the company's market value has to have exceeded its book value, meaning the investing public has perhaps given the company too much credit.
Earnings announcements can create opportunities for investors because they cause adjustments in book-to-market ratios. When a company announces its earnings, those earnings are added to its previous book value, causing the book-to-market ratio to increase. Normally, investors will take an increasing ratio to mean a company is doing well and may be worth investing in. This further investment increases the company's market value and brings the ratio closer to a value of one once again.
One historical problem with using book-to-market ratio as an investment guide is that certain companies have been known for dishonest accounting. Instances of dishonest accounting create artificially high book-to-market ratios that attract investors. When the real book value of a company that does this is finally revealed, the book-to-market ratio, followed by the company's stock price, invariably plummets.