Price-to-earnings and price-to-book are some of the most common financial ratios used to value a stock. While they are both financial ratios that can be used when valuing a stock, they are very distinct metrics that should be carefully considered and analyzed.
Let’s analyze the main differences between price-to-earnings and price-to-book and which one you should use when valuing and analyzing a stock.
What is the price-to-earnings ratio?
The price-to-earnings is the most popular financial ratio used to compare stocks since it correlates the price or the valuation of the company to its earnings. It is calculated by dividing the price of the stock by the earnings per share (EPS) or by dividing the market cap of the stock by its total yearly earnings.
Price-to-earnings = Stock Price / Earnings Per Share (EPS)
Price-to-earnings = Market Cap / Earnings
What the price-to-earnings tells investors
The P/E ratio helps investors calculate how much they are paying for the company’s earnings or how many years it will take to generate the initial investment if the earnings remain stable. It is a measure that can be used for a company’s valuation, and it reflects if the valuation is high or low, as well as the expected future earnings of the company.
A growth company with increasing revenues and earnings is more likely to have a higher price-to-earnings to reflect future profit growth. This means that investors are more likely to pay a higher valuation for a company growing its earnings than a company with declining or stable profits.
How to use price-to-earnings when valuing a stock
There are a few crucial considerations on how to use the price-to-earnings when investing, and we’ll look at each. Historically, stocks with low price-to-earnings are considered value stocks due to their apparent undervaluation and often offer higher returns over the long term.
This happens because if the price-to-earning of a stock is lower than the average or median stock in the index, it is expected to revert to the mean over a certain period.
However, this does not mean that you should discard stocks with higher price-to-earnings. A stock with a higher price-to-earnings simply has more expectations priced into the stock. Therefore, investors are expecting the company to grow faster and to increase its revenues and earnings at a higher pace - that is why the price-to-earnings is higher.
Determining whether or not you should invest in a stock with a higher P/E ratio depends if you think the company will be able to achieve the estimated growth. If the company can grow according to analyst estimates, it will justify the higher valuation. If not, the stock price will decline so that the valuation reflects the lower growth estimates.
What is price-to-book?
The price-to-book (P/B) measures the stock's price relative to its book value, and it is calculated by dividing the share price by the book value per share. The price-to-book ratio measures how much an investor pays for a stock relative to the value of the company’s equity. This is usually a good measure of how much the stock price reflects the company’s assets minus liabilities.
There are a few ways to calculate the price-to-book ratio of a stock:
Price-to-book = Stock price / Book value per share
Book value per share = Assets - Liabilities / Outstanding shares
Price-to-book = Market cap / Book value
How to use price-to-book when valuing a stock
The price-to-book ratio is a simplified measure of the stock’s market cap relative to its equity value. It tells investors how much they are paying for the company’s equity, or in other words, how much the price of the assets minus liabilities of the company.
While it is often a good idea to look for stocks with a low price-to-book, usually under 1, because it means that the company’s assets minus liabilities are worth more than the current stock price, it is not so easy.
Investors will have to determine whether or not the company’s assets might be overstated on the balance sheet. When most investors think the company will have impairments, the price-to-book is low. Therefore it is important to filter through these stocks to avoid blindly investing in them because their price-to-book is low.
What is the difference between price-to-earnings and price-to-book?
While the price-to-earnings measures a company’s ability to generate earnings, and it tells investors how much time investors will wait on average if the earnings remain the same, the price-to-book is a measure of the company’s valuation relative to its equity value.
Both ratios are helpful when deciding whether or not to invest in a stock. However, it is essential to understand how they relate to the company or the industry. Specific industries often have lower price-to-book ratios, reflecting the lower expect growth in the equity value of the company or a higher amount of liabilities on the balance sheet.
Additionally, when considering the price-to-earnings, you should always expect stocks in industries with higher growth to have higher P/E ratios, reflecting the estimated increase in earnings.
Should you use price-to-earnings or price-to-book?
When valuing a stock, price-to-earnings, and price-to-book should be used independently because they tell investors completely different things. Price-to-earnings help investors estimate how many years it will take for their investment to be paid off, while the price-to-book is a measure of the company’s current valuation or market cap relative to the value of the assets minus liabilities.
It is also crucial for investors to understand how the price-to-earning and price-to-book of a stock can vary. While the P/E varies depending on the company’s earnings and the fluctuations of the stock price, the price-to-book varies mainly depending on the stock price. This is because a company’s earnings tend to fluctuate and vary more frequently than the assets and liabilities of a company.
Value investors have constantly used price-to-earnings and price-to-book as two of the most important metrics to find undervalued stocks. Low P/E and low P/B stocks are usually favored by investors with a value approach. Using a screener to find and filter through these stocks is usually a great way to find undervalued opportunities.
Understanding why a stock has a low price-to-earnings and low price-to-book is also a critical part of equity research. In some cases, a low price-to-earnings may signal that the company’s earnings are expected to decline, and the P/E ratio can even be negative. In the same way, a low price-to-book could be a signal to investors that the equity value of the company is declining.