Market to Net Worth ratio defines, how much investors are willing to pay to buy the stocks for every Rs 1 of the Net worth of the company
Formula
Market Cap to Net Worth = Market Capitalization / Shareholder’s Equity
Example:
If a company XYZ’s Market Cap is Rs 1000 Cr in the current year and the Net worth is Rs 500 Cr. Then, Market Cap to Net worth is 2.
For every Rs 1 of net worth generated by the company, investors are willing to pay Rs 2 to buy the company.
How to Use it Practically
When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting shareholder’s equity.
But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in Shareholders Equity.
Market Cap to Net Worth ratio is also tied to Return on Equity. Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio.
The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at Market Cap to Equity, make sure you relate it to ROE.
Although this ratio isn’t very useful for service firms, It’s very good for valuing financial services firms because most financial firms have considerable liquid assets (easily converted into cash ) on their balance sheets.
The nice thing about financial firms is that many of the assets included in their net worth are marked-to-market –in other words, they are re-valued every quarter to reflect shifts in the marketplace, which means the Net worth is reasonably current.