There are numerous ways to evaluate stock outcomes in the Investment World. The most effective form of stock analysis is ‘Relative Valuation.’
A ‘Relative Valuation’ model is an investment valuation strategy that compares the value of a company with that of its peers or industry peers to examine the financial value of the company.
Within this valuation strategy, the two most significant valuation ratios are:
- Price-to-Earnings ratio (P/E ratio)
- Price-to-Book Value ratio (P/B ratio)
These ratios are used in the most famous “Value Investing” approach. Now let us recognise how these ratios enable an investor to select the right stock for their portfolio.
Price-to-Earnings Ratio: The P/E ratio is the indicator of the current market price in value relative to its earnings. Whether you are attempting to decide if the stock is a wise investment, the P/E ratio will help you measure the future stock trajectory and whether the price is fairly high or low compared to the past or relative to other companies in the same sector.
Take a look at it mathematically,
PE ratio = Current Market Price/Earnings per Share
Company Lambda Ltd is trading at $80 and its earnings per share is $15. Hence the PE ratio is 5.33. While Company Theta Ltd is trading at $40 and its earnings per share is $10. Hence the PE ratio is 4.
Consider both the companies are of the same sector. While Theta Ltd is undervalued. Lambda Ltd is overvalued. This ratio is used to analyse two factors:
- The profitability of the company.
- The approach an investor takes about the said profitability.
The P/E ratio signifies the investor’s view of the business performance. In specific ways, it reflects how much a corporation is willing and able to pay for $1 worth of earnings.
Multiple industries have different P/E ratio ranges that are considered to be standard for their industry group. There will often be exceptions, but it is common to find these kinds of variances between sectors and industries. They emerge, in part, from different standards for different businesses.
For instance, A fabric mill is subjected to low-profit margins and low growth prospects could trade at a much smaller magnitude. These principles are not preordained, and investor sentiments can vary towards different sectors.
However, the PE ratio lets an investor assess undervalued stock and overvalued stock. It has its weaknesses if we are to rely on this comparable ratio. An undervalued stock can sometimes not be an attractive stock with a future growth perspective. It could simply mean that the company might be facing some problems like a socio-economic crisis, or bad management, etc…
Price-to-Book Value Ratio: P/B ratio is the market value of the share price of a company over its book value of equity. The book value of the equity, in effect, is the worth of the assets of the company expressed on the balance sheet. The book value shall be specified as the balance between the book value of the assets and the book value of the liabilities.
Below is the mathematical representation,
Book Value Per Share = (Asset — Liabilities)/ Total number of shares
PB ratio = Market Price per Share/Book Value per Share
Let’s consider an example,
Company Sigma Ltd has reported that,
Assets = $150 millions
Liabilities = $ 100 millions
Outstanding Shares = 25 million
Market Price = $5 per share
Applying the above formula,
Book Value per share = (150–100)/25 = 2
PB Ratio = 5.00/2.00 = 2.5
The stock of Sigma ltd is trading 2.5 times more than its book value.
Investors utilize the price-to-book value to observe if the stock is valued correctly. A price-to-book ratio of one implies that the stock price is marked up in accordance with the company’s book value. In other cases, the stock price will be deemed to be reasonably priced, solely from a P/B point of view. A business with a high price-to-book ratio could mean that the stock price is overvalued, whereas a company with a lower price-to-book ratio could be undervalued.
Nevertheless, the P/B ratio should be correlated with companies in the same industry. For some businesses, the ratio is higher than for others. It is, therefore, necessary to equate it with companies with similar assets and liabilities.
The study of the P/B ratio is an important aspect of the overall value investing strategy. Such a strategy implies that the marketplace is inefficient and that businesses are trading considerably less than their actual worth at any given moment.
Investors may notice that the P/B ratio is a good measurement because it can provide a decent way to contrast the market capitalization of a stock with its book value. But, setting a standard and an appropriate price-to-book ratio is not always simple. As stated above, this varies depending on the industry. In certain cases, a lower P/B ratio may mean that the stock is undervalued, but it can also point to fundamental problems with the business.
The bottom line is that using both of these metrics together would give an investor more insight into the stock than just looking at it separately. Both indicators will uncover the financial health and potential growth of the company.
Disclaimer: There are potential risks relating to trading and investing and you should not trade with money that you cannot afford to lose however, for those that educate themselves and adopt appropriate risk management strategies, the potential update can be significant. Please note that all opinions, research, analysis, and other information are provided as general market commentary and not as specific investment advice.
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