Be Aware of the Complications in Using Ratios in Making Your Investment Decisions

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Investing is essentially an endeavor to get an edge over the markets. If you do not care about performing better than the market, you should probably just buy an index fund and match the market returns. If you are a stock investor, there are a few key ratios you need to understand before you invest in any stock. You also need to know the situations where these ratios do not work and may indeed lead you astray.

Price to Earnings Ratio (P/E Ratio)

At its very simple, the Price to Earnings ratio is a measure of how the market values the earnings of the company. You can calculate the P/E Ratio as

P/E Ratio = Total Market Capitalization/Net Income, or alternatively as,

P/E Ratio = Price of the Stock/Earnings per Share

An oft quoted rule of thumb is that the average P/E ratio of the market is around 15. Any stock less than this might be a good value.

Complication in using P/E ratio at its face value

However, things are not always as simple. There are many situations where a P/E ratio might not be a good indicator of the value. For example,

  • P/E ratios are often different in different industries. A growth industry could be valued at a higher P/E ratio compared to an old manufacturing industry
  • P/E ratios might be abnormally high or abnormally low if the company has experienced certain special events that has temporarily impacted the earnings – for example, a one time profit booked for an asset sale. In this case, earnings per share may be high causing the P/E ratio to become low, but since this one off profit event is not likely to be repeated, the market will not reward the company with a higher multiple. Do not make the mistake of taking a low P/E ratio at its face value. Always ask the question if there is a specific reason why it is so low

Price to Book Ratio (P/B Ratio)

Rather than valuing a company based on its profit generating capability as the P/E ratio does, the Price to Book ratio looks at the company valuation based on its book value (see: what is book value?). Essentially, you are looking at the company assets and liabilities and making a value judgment.

Normally, a P/B ratio of less than 1 suggests that the company can be purchased for less than what the net assets are worth, after all debts are paid.

Complication in using P/B ratio at its face value

The book value of the company, as reported on its balance sheet may not be close to the real market value of the assets. Two distinct situations may arise:

  1. Reported book value is less than the market value of the assets: This can occur if the company has many old assets purchased years ago. The value of these assets may not have been marked to the market and are still being carried at the original cost. Some examples are, real estate, inventory (especially if the company uses LIFO inventory method), prestigious office buildings that have appreciated much in value, etc. In these cases, the P/B ratio might be higher than 1, but if you revalue these assets to the current market prices, the company may still be an attractive value.
  2. Reported book value is higher than the market value of the assets: You are more likely to see this situation. For example, if the company has done any acquisitions in the past, it is likely to have Goodwill and Intangibles on its balance sheet as part of the assets. Goodwill represents the premium the company paid to acquire another over and above the fair market value of the acquired company. This premium in most cases turns out to be either vanity or hopes and aspirations of the acquiring company and a conservative investor should zero it out in the book value calculations.

    Intangibles represent intangible assets such as customer accounts, patent portfolio, etc. and do have some value but how much is not easily calculable. Companies tend to be overly optimistic in these cases as well and these values should be discounted. In these cases, the calculated P/B ratio might be lower than 1 but the stock may still not be a good value

PEG Ratio

PEG ratio is calculated as the P/E Ratio divided by the Earnings Growth rate. If a stock has a P/E ratio of 15, and the earnings are growing by 15% a year, then the company has a PEG ratio of 1. Normally, you are advised to look for companies with PEG ratio below 1.

Complication in using PEG ratio at its face value

  • P/E ratio might not be representative. This is covered in the P/E ratio section and care should be taken to adjust for anomalies in the earnings.
  • Earnings growth rate is an estimate and there are countless reasons why this may not be achieved. Earnings growth may slow because of increased competition, economic issues, demand deterioration, or many other factors. If you buy a stock based on the PEG ratio and earnings growth slows, you overpaid for the stock and may not see the profits you expect. It is also likely that earnings growth may in fact accelerate, but these stocks would generally have a high P/E ratio to begin with.

These ratios generally provide a great starting point to start researching a company. Using them in the initial screens can offer up some great stocks you can invest in, but ultimately you should look a little deeper in each of these stocks to make sure these ratios are giving you the right information.