PB ratio (price to book ratio) is calculated as recent close price of the stock divided by book value per share of the company for the most recent financial year. Book value per share refers to the total shareholders investment in the company divided by shares outstanding.
The ratio helps understand the unit price to be paid for the assets leftover after paying all liabilities of the company. Suppose the company has total assets of Rs.250. These assets have been purchased using Rs.180 of debt and Rs.70 shareholders equity. Hence if all liabilities of the company are to be paid off, Rs.180 worth of assets will have to be sold and Rs.70 will remain on the books of the company. If the share price of the company is Rs.300, PB ratio will be calculated as 300 / 70 = 4.3x .
Just as in PE ratio, PB ratio is used for valuation purposes, specially in case of banks and financial companies. Non banking companies do carry large amount of assets on their books, however these assets are not valued on a regular basis, hence there is usually a huge divergence between book value and market value of the assets. On the contrary banks and financial companies regularly value the assets they carry on their books. Hence using PB ratio to value such companies is more appropriate and relevant.
A low PB stock is considered to be undervalued compared to a higher PB one. However it is important to further analyse the reasons behind undervaluation before deciding to buy the stock.