How to Use P/E, P/B and Other Ratios Without Getting Confused?
Have you ever found yourself looking at a stock that’s trading at ₹100 and assuming it’s cheap, only to find yet another stock trading at ₹1,000 that people consider to be cheaper? Have you ever found yourself staring at a web page analyzing stocks with numbers like P/E, P/B, PEG, ROE, ROCE and not having any idea about what all this means? This is where the use of stock valuation ratios comes into play. Ratios allow the investor to determine whether the stock is overvalued or undervalued and also whether the company is efficient in making profit and whether it’s overleveraged. They are important tools of fundamental analysis, especially when choosing between different companies to invest in. There is, however, no single ratio that will allow one to evaluate whether it’s a good time to buy a certain stock. For example, a low P/E ratio may mean that the stock is cheap or that earnings have been going down. A high P/B ratio may point out to growth potential or overvaluation of the stock.
What are Financial Ratios in Stock Analysis?
Financial ratios are computations that are derived from a firm’s financial statements and market data. They aid investors in analyzing companies without having to scrutinize each financial data individually. Some of the questions they may assist you in answering include:
- Is the stock pricey compared to its earnings?
- Is the company making good profits?
- Is it carrying too much debt?
- How does the company’s valuation stand against its competition?
Ratios serve different purposes and once you understand them, stock analysis becomes easier.
1. Price/Earnings Ratio: Is the Stock Overvalued Compared to Its Earnings?
Price to Earnings ratio is a measure comparing the company’s stock market price to its earnings per share (EPS).
Formula:
P/E Ratio = Market Price per Share ÷ Earnings per Share
If a company’s market price per share is ₹200 and earnings per share amount to ₹10 annually, its P/E ratio will be ₹200 ÷ ₹10 = 20. It means that investors pay ₹20 for every ₹1 of annual earnings per share of the company.
What Does a High or Low P/E Ratio Suggest?
High P/E ratio can mean that there are high expectations of growth; on the other hand, it can also mean that the stock is highly valued. A low P/E can either suggest a cheap buy or show negative performance and issues in the business. Therefore, what is a good P/E ratio for a stock? Well, there is no single answer to this question.
When evaluating P/E ratios:
- Compare the firm against other companies of a similar nature.
- Evaluate its historical performance.
- Determine whether the earnings have been growing or falling.
- Determine whether the expected growth justifies the valuation.
You can also come across two kinds of P/E ratios:
- Trailing P/E: Earnings of the past 12 months.
- Forward P/E: Earnings that are expected to come in the future.
- Forward P/E ratio depends upon projections that might or might not come true. P/E ratio becomes difficult to use for negative earnings firms.
2. P/B Ratio: What Is The Company’s Stock Valuation Relative To Its Book Value?
Price-to-Book (P/B) ratio compares stock price with book value per share of a company. Generally, book value stands for net assets.
Calculation:
P/B ratio = Price Per Share ÷ Book Value Per Share
Assume that the price per share of a company is ₹150 and its book value per share is ₹100. P/B ratio of the company is ₹150 ÷ ₹100 = 1.5. Thus, the market is valuing the stock at 1.5 times its book value. If the P/B ratio is low, it may mean that the stock is undervalued or the firm may not be earning sufficiently or may have poor asset quality. Similarly, if the P/B ratio is high, it may indicate that the stock is expensive or there are good growth prospects.
When Is The P/B Ratio Relevant?
P/B ratio is especially relevant for banks and other financial institutions wherein assets, liabilities and capital play a very crucial role in business operations. If the value of a company lies mainly in its brand name, software or intangible assets, book value may be of less importance.
3. P/E vs P/B: Which Ratio Is Better?
Both ratios help assess valuation, but they measure different things.
| Factor | P/E Ratio | P/B Ratio |
| What it compares | Share price with earnings | Share price with book value |
| Main purpose | Valuation relative to earnings | Valuation relative to net assets |
| Particularly useful for | Profitable businesses | Banks and asset-oriented businesses |
| Key limitation | Less useful with negative earnings | Less informative for businesses driven by intangible assets |
Neither ratio has inherent superiority over the other. In some cases, the combined use of P/E and P/B may offer more insight when both ratios are applicable to the firm. A bank, for instance, with low P/B ratio and persistent negative ROE may not necessarily be an ideal investment prospect.
4. PEG Ratio: Is the Stock Undervalued Relative to Its Expected Growth Prospects?
Price/Earnings-to-Growth (PEG) ratio takes into account expected earnings growth along with the P/E ratio.
Formula:
PEG Ratio = P/E Ratio ÷ Expected Annual Earnings Growth Rate
Let us take the case of a firm with a P/E ratio of 30 and expected annual earnings growth of 20%. Then its PEG ratio will be 30 ÷ 20 = 1.5. Low PEG ratio may seem appealing than a high PEG ratio assuming that growth forecast is realistic and both companies are comparable. But there is no PEG ratio benchmark that ensures valuation to be a good investment.
5. Other Financial Ratios Significant to Stock Evaluation
Apart from the price-earnings ratio, the price-to-book value ratio and the price/earnings growth ratio, there are many other ratios which can shed light on the financial performance of a business.
| Ratio | What It Measures | Why It Matters |
| Price-to-Sales (P/S) | Market value relative to revenue | Useful for comparing businesses with low or inconsistent profits |
| EV/EBITDA | Enterprise value relative to EBITDA | Helps compare business valuations while accounting for debt and cash |
| Dividend Yield | Annual dividend relative to share price | Useful for evaluating dividend income |
| Debt-to-Equity | Debt relative to shareholders’ equity | Helps assess reliance on borrowing |
| ROE | Net profit relative to average shareholders’ equity | Indicates returns generated on shareholders’ funds |
| ROCE | Operating profit relative to capital employed | Measures capital efficiency |
| Current Ratio | Current assets relative to current liabilities | Helps assess short-term liquidity |
It is not necessary to compute all ratios for every share. For instance, ROCE may be very helpful in assessing capital intensive industries. Dividend yield is important for an investor looking to earn dividends. Another ratio to think about is the debt/equity ratio in relation to interest cover and cash flows.
How to Analyse a Stock through Financial Ratios
The simplest way to use financial ratios is by grouping them based on their objectives. First, examine valuation. Determine whether the market price looks sensible through the use of P/E, P/B, PEG or EV/EBITDA, depending on the type of business. Examine profitability. Check ROE, ROCE and profit margins to determine the effectiveness of making profits and utilising capital in the business.
Financial risk analysis. Analyse debt-to-equity, interest coverage and cash flows. Just because an organisation makes accounting profits does not necessarily mean that it has made enough cash flow. Comparative analysis. When comparing stocks through financial ratios, ensure you compare similar businesses in terms of models and industries. What is a normal valuation in one industry can be high in another industry. Examine historical trends. Look at the past years to determine the trend in terms of earnings, profitability, valuation and debt position. Lastly, check the financial statements. While ratios provide summary information, they may not explain everything about the changes in a business’s performance.
Common Mistakes To Avoid
While calculating the stock valuation ratios, avoid making the following mistakes:
- Assuming that the low P/E ratio implies value.
- Considering high P/E ratio bad automatically.
- Comparing companies operating in different industries.
- Not considering the debt and earnings quality of the firm.
- Depending completely on growth estimates.
- Making judgments based on the ratio alone.
The point here is not to look for the lowest numbers. The point here is to assess if the stock valuation fits its business performance, potential and risks.
Ratios as Decision-Making Tool
Understanding how ratios work will help make them more meaningful. P/E ratio assesses the relation between value and earnings, P/B ratio relates the price to book value, while PEG ratio looks at expected earnings growth. ROE, ROCE and debt-to-equity ratio provide more information on profitability, capital structure and financial risk. However, any of these ratios alone does not give an answer to the question if a stock is undervalued or overvalued. Rather, it is important to compare relevant ratios, study company’s financial performance and decide if the valuation is justified given future expectations. Financial ratios will enable you to pose more pertinent questions than use ratios as a substitute for finding the perfect stock.
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FAQs
1. What is a good P/E ratio for a stock?
There is no universal ideal P/E ratio. It depends on the company’s industry, earnings growth, profitability, risks and historical valuation.
2. How can I identify an overvalued stock using the P/E ratio?
Compare its P/E with industry peers and historical levels, then assess whether earnings growth and business quality justify the valuation. A high P/E alone does not prove overvaluation.
3. What is a good P/B ratio?
A good P/B ratio depends on the industry, profitability, asset quality and growth prospects. A low P/B does not automatically mean a stock is undervalued.
4. Which financial ratios should beginners know?
Start with P/E, P/B, EPS, ROE, ROCE and debt-to-equity. These cover valuation, earnings, profitability and financial risk.
5. How should I use P/E and P/B ratios together?
Use P/E to assess valuation relative to earnings and P/B to assess valuation relative to book value. Consider both alongside profitability, growth, debt and industry comparisons.
