What are P/E and P/B ratios? How to calculate and use them

P/E and P/B ratios are relative valuation metrics that help investors identify whether a stock is overvalued or undervalued. These ratios are easy to calculate, and comparing them with the industry average or benchmarks like the S&P 500 can help inform investment decisions. In this article, we will discuss the P/E and P/B ratios in detail, how they’re calculated, and how they can be used to evaluate stocks.

What is the P/E ratio?

The P/E ratio, or the price-to-earnings ratio, is a valuation metric that compares a company’s share price to its earnings per share (EPS). It is the price investors are willing to pay for every dollar of a company’s profit. The formula for calculating the P/E ratio is as follows:

P/E ratio = Market price per share / Earnings per share

The EPS can be calculated using past data or projected future outcomes. The trailing P/E represents the ratio using the last twelve months of the company’s earnings. Conversely, since companies can project earnings, investors can also calculate forward P/E using projected future earnings. A high P/E ratio suggests investors are willing to pay a premium for every dollar of profit a company generates. Conversely, because earnings can be negative, the P/E ratio can be negative as well. 

• If expectations of future earnings are high, the forward P/E ratio will usually be high. For example, companies in the tech sector tend to grow faster: as such, they typically have higher P/E ratios. As of this writing, companies in the information services industry have an average P/E ratio of 1,681.57 (roughly 100x the average P/E ratio of the S&P 500). A higher P/E ratio could also mean the company’s stock is overpriced – the market may have overestimated the company’s potential.

• On the other hand, if expectations of future earnings are low, the forward P/E ratio will also usually be low. For example, mature companies in stable sectors tend to be slower growing; as such, they typically have lower P/E ratios. As of this writing, the US steel industry has an average P/E ratio of 6.42 (less than half the average P/E ratio of the S&P 500). A lower forward P/E ratio could also mean that expectations are too low, which might translate to an investment opportunity as the market may have underestimated the company’s potential. 

What is the P/B ratio?

The P/B ratio, or the price-to-book ratio, is a valuation metric that compares a company’s market value to the value of its assets. It is the price investors are willing to pay for every dollar of a company’s assets. The formula for P/B is as follows:

P/B ratio = Market price per share / Book value per share

P/B is calculated by dividing a company’s share price by its book value per share. The book value is calculated by subtracting intangible assets (such as brand value or intellectual property) and liabilities from total assets. A high P/B ratio suggests that investors are willing to pay a premium for the company’s book value. This might indicate that the company is receiving high returns on its assets. Conversely, a low P/B ratio might indicate that the company’s current stock price is undervalued relative to its assets. 

• If the return on assets is high, the P/B ratio also tends to be high. Typically, companies with significant intangible assets tend to have high P/B ratios since they are difficult to account for. For example, Apple has a P/B ratio of 45.1 (roughly 15x the average P/B ratio of the S&P 500). A high P/B ratio could also mean the company’s stock is overpriced and investors are overconfident about its assets.

• On the other hand, if the return on assets is low, the P/B ratio also tends to be low. Typically, capital-intensive businesses such as banking or real estate have low P/B ratios. For example, America’s largest bank JPMorgan Chase has a P/B ratio of 1.4 (almost half the average P/B ratio of the S&P 500). A low P/B ratio could also mean the company’s stock is underpriced, which might translate to an investment opportunity as the market may have underestimated its assets.

How to use P/E and P/B ratios

Investors can use P/E and P/B ratios to assess different aspects of a company’s valuation. When using these ratios, investors should consider industry benchmarks and compare them with peers in the same sector. Here are a few things to consider when using these ratios:

• P/E ratios are particularly useful when evaluating growth stocks, as a high ratio may indicate market optimism and future earnings potential. However, the P/E ratio alone provides limited information about a company’s future earnings growth. It can be influenced by factors such as share buybacks or changes in accounting methods. Therefore, investors often use the Price/Earnings-to-Growth (PEG) ratio to take earnings growth into consideration. 

• P/B ratios are more relevant for asset-heavy industries, such as banking or real estate, where the ratio can highlight undervalued stocks based on their tangible assets. Nevertheless, it is important to note that P/B ratios do not consider intangible assets or other factors such as debt or capital depreciation. The book value of a company’s assets can also be manipulated by a company increasing or decreasing its cash reserve or doing share buybacks. For a comprehensive picture, investors can use the Return on Equity (ROE) indicator to see how much profit is being generated by the company’s assets. 

Frequently Asked Questions (FAQs)

1)What are P/E and P/B ratios?

P/E and P/B ratios are relative valuation metrics used by investors to assess whether a stock is overvalued or undervalued.

2)How is the P/E ratio calculated?

The P/E ratio, or price-to-earnings ratio, is calculated by dividing the market price per share by the earnings per share (EPS) of a company.

3)How is the P/B ratio calculated?

The P/B ratio, or price-to-book ratio, is calculated by dividing the market price per share by the book value per share of a company.

4)What does a high P/E ratio indicate?

A high P/E ratio suggests that investors are willing to pay a premium for every dollar of profit a company generates. It may indicate market optimism and expectations of future earnings growth.

5)What does a low P/E ratio indicate?

A low P/E ratio suggests that the market may have underestimated the company’s potential. It could indicate undervaluation or low expectations of future earnings growth.

6)What does a high P/B ratio indicate?

A high P/B ratio suggests that investors are willing to pay a premium for the company’s book value. It may indicate high returns on assets or overconfidence about the company’s assets.

7)What does a low P/B ratio indicate?

A low P/B ratio suggests that the company’s current stock price is undervalued relative to its assets. It could indicate undervaluation or low returns on assets.