Money Matters

Pay attention to these ratios when evaluating stocks

October 6, 2012 

Q. I’m new to investing and somewhat familiar with the price/earnings ratio, actually just enough to know that the lower the better. Could you explain the price/book ratio and how these two should be analyzed to determine whether a stock is a good buy at the current price?

Welcome to investing 101! You are asking about two of the best-known investment valuation indicators.

A low price/earnings ratio is not always better. It is usually an indicator of whether a stock is considered a growth or value stock. Historically, the average P/E ratio for the broad stock market has been 15. The formula for the P/E ratio is the stock price per share divided by the earnings per share. The numerator of this formula is straightforward, the price of a share of stock. The denominator is a different story. The EPS is calculated by dividing the company’s reported net earnings by the weighted average of common shares outstanding. You need to determine upon what the EPS number is based. It may be based on the past 12 months of income (trailing EPS), a forward 12-month projection, a combination of past and projected, operating cash flow versus net income, or assumptions of earnings due to expectations concerning something that a company is planning. The reliability of the P/E ratio as a basis for buying a stock has a lot to do with the accuracy of the EPS number used in the formula. The trailing EPS is the most common number used in the calculation.

A high P/E generally means that investors will pay more for the company’s stock because they are convinced that the company will be able to increase earnings. When P/E ratios of 40 and above were common in the late 1990s, raging bulls insisted that P/E ratios were irrelevant.

A low P/E generally means that investors don’t think earnings will grow and will not pay as much for the stock, but other investors will view this as an opportunity to buy shares of a company that is undervalued. P/E ratios were low in the 1980s, and bears were touting that the worst was yet to come. As is often the case, both the bulls and the bears were unable to predict the direction of the market.

The price/book ratio of a company is calculated by dividing the market price of the stock by the company’s per-share book value. The per-share book value is arrived at by dividing the reported shareholders’ equity (assets minus liabilities) by the number of outstanding common shares of stock. A high P/B generally means that the price of a stock exceeds the actual worth of the company’s assets. Alternatively, a low P/B would indicate that the stock is selling at a low price compared to the underlying assets of the company.

A low P/B also could mean there’s something fundamentally wrong with the company. Historically, the P/B market average has been 1.5. The usefulness of the P/B ratio varies by industry. Some companies may have valuable intangible assets that may not be reflected or are undervalued as reported in the company’s balance sheet. Examples of these would be intellectual property, brand names and patents. Excluding the value of these causes the P/B value to be higher than it would be if these intangibles were included.

The P/E and P/B ratios are valuable tools when screening stocks, but they are no guarantee that you are buying a stock at an attractive price. While you are learning about the various screening tools used to analyze stocks, investing in mutual funds or exchange-traded funds may be best.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624

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