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Price to earnings multiple vs price to book value

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Now that the quarterly earnings season is coming to a close, analysts are revising estimates for company earnings and coming out with new price targets. Future price estimates for stocks are based on valuation parameters such as price-earnings (P-E) multiple or price-to-book value. Both these metrics are important and serve a distinct purpose in stock valuation techniques. So which one should you use?

 

P-E multiple

 

Mathematically you can calculate this by dividing the current market price of a stock with the annual earnings per share (net profit divided by the number of shares issued). It indicates whether the price of a company’s stock is moving in line with it expected earnings growth. The P-E of a stock reflects the future earnings growth expectation from a company. When that expectation increases, the stock is expected to trade at a higher P-E and hence, the stock price rises. If a stock is trading at a low P-E multiple, the chances of price rising are high if growth is expected to go up and vice versa. But this is not always the most relevant financial ratio to consider while valuing stocks. P-E needs to be seen in context to industry and what others in the industry are trading at. In some cases, notably the banking industry, earnings are not the most appropriate measure for valuation as banks are involved in both lending and borrowing, and a more critical aspect is net margins and asset quality. Also, in cases where a company is restructuring or coming out of a bad earnings period or losses, P-E may not be the best metric to consider as the denominator may not be reflective of future growth. An important caveat is that the ratio is dependent on the quality of earnings declared which depends to a great extent on the accounting practices used.

 

Price-to-book value

 

It is calculated by dividing the current market price with the book value of equity or the book value of assets less liabilities. Ideally, a company should be trading at a stock price which is at least equal to its book value. If it is lesser than that, then it is either because the assets are not earning a good return or the value of assets is overstated. In case the value is overstated its best to avoid the stock. But this requires careful evaluation of the business and balance sheet. As a rule of thumb, the price-to-book value of a company with growing earnings should also be rising. A high price-to-book value can reflect the fact that the earnings expectations from a company are already priced into the stock value. While this is a financial measure which is very useful, relevant and preferred over P-E in certain industries, there are many drawbacks. A company with high debt and proportionately lower value of equity can have a high price-to-book value which is likely to distort matters as the cost of debt is not considered. Moreover, it works best for industries with high capital investment. Lastly, book value of assets is not reflective of market value of assets and high or low cash balances can impact the value without any impact on earnings. The answer really in lies in using both these metrics in context to industry ratios and other operating ratios. In isolation neither of the two is likely to throw up an accurate valuation analysis of a stock.

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