Buying Stocks (value investing) using financial ratio : Valuation Analysis -1

Thursday, March 3, 2011

P/E Ratio

P/E Ratio = Price of share/ Earning per share (annual) of the audited result

For example, if a company is currently trading at $45 a share and earnings over the last 12 months were $2.25 per share, the P/E ratio for the stock would be 20.00 ($45/$2.25).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 ($45 for $2.25) of  current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Price/Book value :

The book value of a company is an estimation of the value per share if it were to be liquidated. How much value can an investor get per share if all the assets is liquidated.
The price/book value ratio, often expressed simply as "price-to-book", provides investors a way to compare the market value, or what they are paying for each share, to a conservative measure of the value of the firm.



If a company's share price is lower than its book value, it can indicate one of two possibilities. 
1.) The first scenario is that the stock is being undervalued by investors because of some transitory circumstance and represents an attractive buying opportunity at a bargain price. It is assumed that the company's fundamentals are intact and will eventually lift it to a much higher price level.

2.) On the other hand, if the market's low opinion and valuation of the company are correct, it will be perceived at its worst as a losing proposition and at its best as being a stagnant investment.


1.) Generally company's assets are recorded at historical cost that its book value is outdated so of limited use.
2.) Intellectual property particularly is difficult to assess in terms of value. Book value may well grossly undervalue these kinds of assets, both tangible and intangible.
The P/B ratio therefore has its shortcomings but is still widely used as a valuation metric. It is probably more relevant for use by investors looking at capital-intensive or finance-related businesses, such as banks.



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