Multiple price-earnings vs book value

Now that the quarterly earnings season is drawing to a close, analysts are revising corporate earnings estimates and proposing new price targets. Estimates of future stock prices are based on valuation parameters such as price-earnings multiple (PE) or book value. These two metrics are important and serve a separate purpose in stock valuation techniques. So which one to use?

Multiple PE

Mathematically, you can calculate this by dividing the current market price of a share by the annual earnings per share (net earnings divided by the number of shares issued). It indicates whether a company’s stock price is moving in line with expected earnings growth. A stock’s PE reflects expectations for a company’s future earnings growth. When this expectation increases, the stock should trade at a higher PE and therefore the stock price increases. If a stock is trading at a low multiple of PE, the chances of a price rise are high if growth is expected and vice versa. But this is not always the most relevant financial ratio to consider when valuing stocks. The MOU should be seen in the context of the industry and what other industry players are negotiating about. In some cases, especially in the banking sector, profit is not the most appropriate measure for valuation because banks are involved in both lending and borrowing, and a more critical aspect is net margins and profitability. asset quality. Additionally, in cases where a business is restructuring or coming out of a bad period of profit or loss, PE may not be the best metric to consider as the denominator may not reflect future growth. An important caveat is that the ratio depends on the quality of the reported profits which depends to a large extent on the accounting practices used.

Price to book value

It is calculated by dividing the current market price by the book value of equity or the book value of assets less liabilities. Ideally, a company should trade at a stock price at least equal to its book value. If it is lower than that, it is either because the assets do not generate a good return or because the value of the assets is overestimated. In case the value is overestimated, it is better to avoid the stock. But it requires careful assessment of the business and the balance sheet. Typically, the price to book ratio of a company with growing profits should also increase. A high price-to-book ratio may reflect that a company’s earnings expectations are already built into the stock’s value. While this is a very useful, relevant and preferred financial measure over PE in some industries, it has many drawbacks. A business with high debt and proportionately lower equity value can have a high price to book ratio, which is likely to skew things because the cost of debt is not factored in. Additionally, it works best for industries with high capital investment. Finally, the book value of assets does not reflect the market value of the assets and high or low cash balances can affect the value without impacting earnings. The answer really lies in using these two measures in the context of industry ratios and other operating ratios. Taken in isolation, neither is likely to generate an accurate analysis of a stock’s valuation.

To subscribe to Mint newsletters

* Enter a valid email address

* Thank you for subscribing to our newsletter.

Never miss a story! Stay connected and informed with Mint. Download our app now !!

Comments are closed.