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The proper and improper uses of P/E and P/B ratios.
Non-Independent Investment Research (/about/niird)
P/E and P/B ratios are some of the most-used financial ratios because of their simplicity. But within their simplicity lies large negative implications for
investors and traders.
Price to Earnings Ratio
Because the meaningfulness of the ratio is highly dependent on earnings stability, P/E is most easily understandable and meaningful for stable and /or
defensive companies. Companies like grocery chains or utilities, which tend to have earnings or revenues that grow slowly but steadily, are usually good
candidates for valuation using Price to Earnings ratio since the earnings portion of the ratio does not tend to change rapidly.
On the other hand, fast growing and cyclical companies can greatly mislead investors using Price to Earnings ratios. High growth stocks with P/Es above
50 or 100 times, are not necessarily expensive if the growth of the company can sustain the valuation. For these types of companies or industries, it is
often useful to use the Price to Earnings to Growth ratio (PEG).
The PEG ratio can be a good valuation multiple when compared using the company’s sector. The PEG is the price of growth that an investor is willing to
pay, but it can only be used for companies in similar industries with relatively high levels of growth. For example, let’s assume Company A is trading at
P/E of 20 while Company B is trading at a P/E of 15, while Company A is growing at 15% and Company B is growing at 10%. Which company is more
expensive? Does the higher growth of Company A compensate investors for the higher valuation of A? By using the PEG ratio on both companies, we can
quickly calculate that the PEG for Company A is 1.33(P/E/G=20/15), while Company B has a PEG ratio of 1.5. So while the P/E ratio for Company A is
actually higher, on a growth basis Company B is actually more expensive with a higher PEG ratio. For companies with low growth or with a dividend yield,
the PEG is not a good valuation measure. Additionally the PEG ratio is only a comparative ratio, meaning that the ratio should only be used to compare
similar companies.
P/E ratios are also highly susceptible to industry and sector factors and therefore P/E ratios can vary greatly depending on the type of industry. Utilities
for example, because of their low growth and high capital needs, usually trade at a ratio of below 10. Technology companies on the other hand usually
trade at 15 to 20 times earnings or more, simply because the industry tends to have a higher growth than utilities and also tend to use much less capital
to earn those returns.
One of the most important things to know about the Price to Earnings ratio is how to use it with cyclical stocks. Highly cyclical stocks tend to have their
best earnings at the peak of the business cycle. When the economy is roaring, cyclical stocks’ earnings will dramatically increase, sending their P/Es
downwards. Therefore what might appear cheap is not truly so. The opposite also happens during recessions, when cyclical stocks might have really high
or even negative P/Es and for naïve investors this would signal that the stock is expensive. The low earnings simply increase the P/E as the denominator
becomes smaller, making the P/E explode. While the company appears expensive it is actually at its cheapest point.
Earnings Visibility - Investors do not like the unknown!
Because P/Es are based on the companies’ future earnings growth, a company with a high growth visibility will normally trade at a higher P/E and higher
PEG ratio, than a company with a lower growth visibility. For example, a company like Novo Nordisk
(https://www2.saxowebtrader.com/Eqr/preview.aspx?id=DK0060102614&la=en&lc=en-gb&pphk=1,0&list=Default&env=1) , which researches and produces
insulin products for diabetics, has a high earnings visibility relative to its peers because of the growth of diabetes in the developed world and because of
its market share in this area. Unless diabetes is cured or Novo Nordisk loses its dominant position in the insulin field, the company’s cashflows and
earnings are relatively more safe than some of its pharmaceutical competitors.
A community for traders of forex,
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Matt Bolduc (/traders/matt-bolduc), Equity Analyst
Filed in CFD Education (/blogs/cfd-education)
Denmark,
25 January 2012 at 08:43 GMT+0

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Similarly, Apple (http://www.tradingfloor.com/blogs/equity-daily-theme/is-apple-like-microsoft-or-more-like-samsungnokia-582315404) which has grown
earnings by 641% in the last 4 years, is only trading at a P/E of approximately 15 times. Because investors do not know what the next great Apple product
will be, and therefore do not know where the earnings from the company will come from in the future (low earnings visibility), investors are valuing
Apple’s earnings at a historically relatively low multiple.
Surprisingly, Facebook (http://www.tradingfloor.com/blogs/equity-daily-theme/facebook-ipo---is-the-company-really-worth-100-billion-1385637144) ,
which is does not have much earnings visibility and is only dependent on advertising income, is expected to be valued at around USD 100 billion from its
expected 2012 IPO, with an expected PE of approximately 100. An investor might wonder; would I rather spend $100 billion and own a portion of Apple
(http://www.tradingfloor.com/blogs/equity-daily-theme/is-apple-like-microsoft-or-more-like-samsungnokia-582315404) or Berkshire Hathaway or Exxon
Mobil, or would I prefer to own Facebook (http://www.tradingfloor.com/blogs/equity-daily-theme/facebook-ipo---is-the-company-really-worth-100-billion-
1385637144) ?
Academic Research on P/E ratios
What to take from this analysis of the Price to Earnings ratio? Well historically the best returns on average have come from companies with lower P/E
ratios. And you may ask why that is? Well in general, investors tend to be too optimistic about a company’s growth and expect that that the highest
growing companies will continue to grow at the same rate into the future. Due to competitive forces this is rarely the case. On the other side of the coin,
investors tend to punish too heavily the stock price of companies that have had bad years or bad quarters. Simple rule to follow: winners tend to have
price ratios that are too high making them overvalued, while losers tend get undervalued for the same reason. Therefore generally the previous losers
(low P/E stocks) will outperform the previous winners (high P/E stocks).
Price to Book ratio
Although not used as often as the P/E ratio, the Price to Book ratio can sometimes provide investors with useful information. The P/B ratio is even more
dependent on the industry the company is in than is the P/E ratio. Just like the P/E ratio, P/B is highly affected by the industry. For example many
technology companies can trade at a price to book of 10 or more, while banks will mostly trade around 1. What accounts for this massive difference? The
biggest difference is highlighted by the industry’s use of capital. Technology firms do not use much physical capital to create earnings. A perfect example
is Microsoft (http://www.tradingfloor.com/blogs/equity-daily-theme/what-would-you-pay-for-this-stock-that-buffett-likes-888192146) which is mainly a
software company. Microsoft (http://www.tradingfloor.com/blogs/equity-daily-theme/what-would-you-pay-for-this-stock-that-buffett-likes-888192146)
mainly needs human capital to create earnings; the business model is not capital intensive. On the other hand, banks require a lot of capital such as
bank deposits, and bonds and so on. And because banks tend to hold relatively liquid assets on their balance sheets, these assets can be valued at their
fair market value. This means that a bank’s balance sheet should be equal to the fair market value of its assets or 1.
One of the useful ways of using the price to book valuation metric is to attempt to value the balance sheet of company. Less liquid assets can carry
greater values on the balance sheet than they are truly worth. In boom times the book value can rarely be used for ‘bargain hunting’ as most companies
will not trade under a book value (clear net assets) of 1. In busts or in recessions, the P/B is of more use at it lets investors bargain hunt for deeply
undervalued companies (http://www.tradingfloor.com/blogs/equity-daily-theme/the-good-and-the-bad-of-undervalued-small-caps-639776634) .
A P/B ratio of under 1 for liquid companies such as banks (or others) usually happens when the market is fearful of a destruction of the equity value of
the company (http://www.tradingfloor.com/blogs/equity-daily-theme/unicredits-slaughter-ends-rights-issue-option-for-european-banks-1046195037) .
This can happen due to leverage - does the financial crisis ring a bell? As a general rule, the more liquid are a company’s assets the closer the Price to
Book will be to 1, all else being equal. And the more earnings a company can generate through balance sheet assets, the higher the Price to Book will be.
A final note on valuation
There are no valuation measures that completely tell the whole story or that even comes close to telling the whole story, but knowing some of the basic
pitfalls can help investors avoid expensive mistakes.

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