You must Sign In to post a response.
  • Category: Stock Market

    What is the role of PE ratio and PB ratio in deciding the valuation of a company?


    Want to know all about valuating a company? Interested in understanding the difference betweem PE and PB ratio? Find responses from experts for this query here.

    A stock market is a place where people invest or trade-in a given stock. There are two basic methods by which stock can be analyzed i.e. technical analysis and fundamental analysis. Fundamental deals with checking various ratios to judge the market position and strength of a company. PE ratio and PB ratio are one of such ratio. What is the role of the PE ratio and PB ratio in deciding the valuation of a company?
  • Answers

    5 Answers found.
  • There are many financial ratios used by the financial analyst to assess a company in the stock market. PE (P/E) and PB (P/B) are two of such ratios and are the important ones. Let us go through them one by one.
    PE ratio is price to earning ratio. The company which is listed in the stock market has a current price for its share. The company also will have an earning during the year. Depending upon how many shares are there in the market issued by the company there will be an entity called earning per share (EPS). If we divide the current market price by its EPS then we get PE ratio.
    How can we use this information for understanding the performance of the company share? A high PE ratio can be there when the share of the company is quoting very high but its earnings are not commensurate. Then the analysts say that the share of the company is overvalued. It is obvious that investor should be cautious in buying such stocks as they are already overvalued and at any time could come down. On the other hand the low PE ratio gives an indication that share price is less in the market though the company has adequate EPS. So, PE ratio gives us some insight into the share performance in the market. Many long term investors prefer to invest in low PE companies to get good yield (return on investment by way of EPS) on their investment. If share prices increase in the future then capital gain would also be there for them in addition.
    Let us now understand about PB ratio. Every company is having a book value which indicates how much assets (net asset) the company has. The PB ratio is found by dividing the company's stock price per share by its book value per share (BVPS). A high book value shows that company is having robust financial position so it is obvious that its share should also quote in market in a corresponding way and if does no happen then the PB ratio would be low. The analyst find the PB ratio sector wise as the investment decisions would vary sector wise. Generally PB ratio is seen in conjunction with return on equity (ROE) and if ROE is increasing PB should also show upward signs. As a thumb rule PB values below 1 (one) are treated as a positive sign for investing in that share. Many experienced and ambitious investors even go for the PB ratios less than 3 (three).
    One important thing about these ratios that I would like to mention is that we should not see them just for the current year or last year but try to find what was the historical pattern of those ratios for that company as that gives a better wisdom for investing.

    Knowledge is power.

  • In general fundamental analysis is of two types which are quantitative and qualitative analysis. Quantitative analysis is what you are asking which is all about analysing the financials i.e. profit and loss statements or balance sheet statements, computing various ratios and then drawing investing decisions. On the other hand, quantitative analysis is all about analysing qualitative features such as management, employees etc. The P/E ratio is the price-earnings ratio. The formula of computing this ratio is hidden in its name i.e. P/E ratio= Market Price/Earning per share.
    Now, you can easily get the market price of the share and earning per share is obtained by dividing profit after tax by the number of issued shares. In general, there are two ways through which the P/E ratio is calculated one through the past year profits and the second through estimated profit. Now, coming to analysis P/E ratio is the amount that an investor is ready to spend to earn 1 rupee on that share. For instance, if the P/E ratio is 10 then an investor is ready to spend 10 rupees for earning 1 on that share. As a thumb rule, you can take lower P/E as a cheap stock but there are certain exceptions to this rule because the stock price of certain stocks can be reduced due to some market news as capital markets are mostly governed by the psychology of traders. You can also judge this by comparing your selected stock to two parameters first to the stick of the competing company and second to the industry average.

    Now, coming to the P/B ratio, it is a price to the book ratio. The formula for computing it is, Share price/Book value per share. Book value is nothing but obtained by deducting liabilities from the assets of the company. After obtaining book value, divide it by the total number of shares to get book value per share. It depicts the amount an investor is ready to pay for obtaining 1 rupee of a net asset in that company. For instance, if the P/B ratio is 10 then the investor is ready to pay 10 rupees for every 1 rupee of net assets. There is no certain parameter but this ratio can not be applied to companies that have very low net assets like IT companies or other service providers companies because they are dependent on their employees. Also, for those companies whose assets are highly depreciating or can't be liquidated easily because of their obsolete models, we can not rely on their book value as accounts are maintained on the historical cost. So, as such, there is no general rule in the stock market but through regular watch, on the market and deep analysis, an investor can draw better conclusions.

  • PE ratio is the ratio of the close price of the stock and the earnings per share. In calculating the earnings one should remember that extraordinary items should not be added. The earnings of the most recent fiscal year are to be taken. The ratio will be useful to understand how many units of stock price are required to purchase a single unit of the company's earnings per share (EPS).
    For Ex: Say the trading value of the share is Rs.600. EPS of the company is Rs.30, then the PE ratio is 600/30 = 20x. You can understand that you have to spend Rs.20/- to get one rupee of the company earnings per share.
    PE ratio will help us to know whether the company is undervalued or overvalued. Before going for the purchase of a share, one has to compare this ratio of various companies operating in the same field or making the same product.
    Let us say there are two competitors in the same field. If the PE ratio of a company is 20 and the other company is 25. Many people will go for a company which is having lower PE value. But before coming to that decision one should know the reasons for the undervaluation. Sometimes some companies expect that their market will increase and hence they expect faster growth. In such a case, an even higher PE ratio may be preferred.
    PB Ratio:
    The recent close price of the stock will be divided by book value per share of the company for the most recent fiscal year to get this PB Ratio. The total shareholder's investment is to be divided by the number of shares outstanding to obtain book value per share.
    Suppose the company has total assets of Rs.350. The company is having Rs.250 loan and Rs.100 shareholders equity. If the company has to sell the assests and clear the loan, there will be R100/- only will be there with the company. If the share price of the company is Rs.300, the PB ratio will be calculated as 300 / 100 = 3x
    PB ratio is used for valuation purposes, especially in the case of banks and financial companies.
    A low PB stock is considered good for the purchase of shares. But one should not go by this ratio only. There are many other points that are also to be considered.

    drrao
    always confident

  • Yes, very good question about dealing with the share market. Both PB and P/E ratio is important. I think the below-given details will help you to understand.

    1. PB ratio or price to book value ratio is the price you are paying to invest the share in comparison to its actual book value. suppose the market price of one share of a company is Rs.1000 which you are expended to purchase. Now, what is the actual value calculation of one share as per the value of that business enterprise?
    i,e, the total value of Assets...............?
    less: the value of liability......................?
    less: Intangible assets if any................?
    Net Asset A
    PB ratio = Net Assets (A)/ Nos of outstanding equity share
    suppose the resultant value comes to Rs. 800
    Now PB ratio = 1000/800 = 1.25
    This means you are paying Rs.1000 for a share whose real book value is Rs.800 and if the company goes on liquidation/bankruptcy you can recover Rs.800 maximum.
    So while purchasing or investing this ratio is important. Generally, this ratio should be near to one except for IT companies where it may be up to 5 or 8 also because they have high intangible assets.

    2. In the case of PE ratio it indicated the Market value you are paying in comparison to earnings from it. Every profitable company has made some profit and distributed a portion from it to the shareholders as dividends. This is the income from your investment with a share if you do not sell out it. Someone traded shares in the stock market and earn profits. Some do not trade but hold it for earnings also in the form of dividends.
    Now PE ratio is the Market price of one share divided by earning per share in the last twelve years. Suppose in company X, the earning per share is Rs.10, and the Market price of one share is 100. PE Ratio will be 100/10=10 i,e, ten times. So high PE Ratio is not good for investors because you are paying a higher cost. Hence while investing with any share the above two elements are important. It will exhibit the valuation status of the company. I think it is clear from the above discussion. Thanks.

    Believe in the existence of God the superpower.
    Regards
    Dhruba

  • The true value of a firm can be assed through the approach of PE and PB ratios. PE ratio is defined as the intrinsic value of the company with respect to its earning potential. These ratios can be verified through through the ratios of the other companies operating on the production of the same products and you can evaluate the values of PE and PB ratios.
    This tool would help you in determining of the stocks of the right time of its buying or its selling. Through the application of a PE or PB multiplier, you would be able to determine the nature of its overvaluation or otherwise.
    Working with PE and PB ratios- You have to calculate the price of earning ( PE) ratio and the price of book ( PB) ratio.The PE ratio is calculated with the division of the stock price by earning per share. Earning can be found out on the income statement included within the annual report.
    The PB ratio can be determined by dividing share price by the equities of the stockholders.
    Determination of value based on PE ratio - You have to find out the average of PE ratio of other companies of the same industries producing the same products where you can compute their PB ratios of each industry. Such computations would reflect whether the price is overvalued or undervalued.


  • Sign In to post your comments