The trader's profession: P/E, P/B and PEG ratios
Igor Dombrovan, Managing Director of Saxo Bank in Russia
P/E and P/B ratios Due to their simplicity, they are among the most frequently used financial indicators. However, this simplicity has serious negative implications for investors and traders.
Price/profit ratio
P/E ratio (the ratio of the market price of a share to net income per share) depends on the stability of profits, so this indicator is considered particularly important and illustrative for stable and/or low-risk companies. The best way to assess the effectiveness of price/earnings ratio The P/E ratio can be used for companies with slow but steady growth in profits or revenues because the profit component of the ratio is not prone to sudden changes, such as utilities or, for example, grocery stores. On the other hand, fast-growing and cyclical companies using P/E ratios can be very disorienting for investors.
Fast-growing stocks with P/E ratios above 50 or 100are not necessarily expensive if the company's growth rate is capable of delivering that value. Companies or industries of this type can often benefit from the use of PEG ratioThe PEG can be a good valuation ratio when comparing companies within the same sector. PEG can be a good valuation ratio when comparing companies within the same sector. PEG is the price an investor is willing to pay for growth, but it is only applicable to companies with similar businesses and relatively high growth rates. For example, the P/E ratio is 20 for Company A and 15 for Company B, but Company A is growing at a rate of 15% and Company B is growing at 10%. Which one is the higher valued company? Does Company A's higher growth rate compensate for the higher value of its stock to investors? By applying the PEG ratio to both companies, we can quickly calculate that Company A has a PEG value of 1.33 (P/E/G=20/15), while Company B has a PEG value of 1.5. Although the actual P/E ratio is higher for Company A, from a growth perspective Company B is more expensive and is characterized by a higher PEG ratio.
However, this indicator will not be a reliable evaluation criterion for companies with low growth or dividend profitability. In addition, the PEG ratio is only comparative in nature, i.e. it can only be used to compare similar companies. Also P/E ratios are extremely sensitive to the type of economic activity and factors specific to the sector, and therefore can vary widely across industries. For example, utilities, with their low growth and high capital expenditure requirements, typically have multiples below 10. On the other hand, technology companies typically have multiples of 15-20, simply by virtue of the fact that this industry has traditionally had higher growth rates than utilities and also employs a much smaller amount of capital to generate profits. To wit. the most important knowledge about the price/profit ratioIn the case of cyclical stocks, it is used for cyclical stocks, whose earnings change exactly in line with the business cycle and peak at its peak. When the economy is booming, earnings on cyclical stocks skyrocket, sending the P/E down. Therefore, what may appear cheap at first glance is actually not. The reverse is true during recessions, when P/E ratios can be very high or even negative, prompting investors to view these stocks as expensive. Low earnings simply inflate the P/E value because of the decreasing magnitude of the denominator. The company appears expensive, even though it is actually at the cheapest possible levels.
Profit visibility - Investors don't like unknown values!
Since P/E ratios are calculated based on a company's projected future earnings growth rate, prominently growing companies typically have higher P/E and PEG ratios than companies whose growth is less obvious. For example, Novo NordiskThe company's insulin research and insulin-containing products for diabetics are distinguished from other industry peers by visually striking high margins due to the increasing incidence of diabetes in the developed world and the size of the segment the company occupies in the market. Until diabetes is defeated or Novo Nordisk loses its dominant position in the insulin drugs market, the company's cash flow and profits will be relatively safe compared to a number of its competitors in the pharmaceutical industry.
Similarly, Apple's profits has grown by 641% over the past 4 years, but the P/E ratio is only about 15. Investors value Apple's earnings so low by historical standards because they have no idea what the next ingenious product the company will invent, and consequently don't know where to expect its future profits to come from (low visibility).
It's amazing that Facebookwhose profits are not too obvious and depend solely on advertising, could be valued at around USD 100 billion when it hits the market. IPO in 2012, with the PE ratio expected to roughly reach the 100 mark. An investor may wonder whether it is better to spend $100 billion and acquire a stake in Apple, Berkshire Hathaway or Exxon Mobil, or to own Facebook.
Scientific study of the P/E ratio
What lessons should be learned from this P/E analysis? Historically, best returnsOn average, companies with lower price/earnings ratios demonstrated the same results. Why, you may ask. Because, in general, investors tend to be overly optimistic about firm growth and expect that the fastest growing companies will continue to maintain the same growth rate in the future. This is usually rarely the case due to the laws of competition. On the other hand, investors tend to severely undervalue stocks of companies experiencing a bad year or a bad quarter. The result is a simple rule of thumb: winners get overpriced, making them overvalued, while losers remain undervalued for the same reasons. Therefore, former losers (low P/E values) tend to outperform later former winners (high P/E stocks).
Price/book value ratio
While this metric is used less frequently than P/E, it can sometimes arm an investor with valuable information. P/B ratio (ratio of the market price of a share to its book value) even more than P/E, depends on the company's business area and, like P/E, is largely industry-specific. For example, many technology companies have a P/B of 10 or higher, while bank stocks trade at around 1. What is the reason for this significant difference? The main difference has to do with the use of capital required in the industry. Technology companies do not require large amounts of tangible assets and physical capital to generate profits. A great illustration would be Microsoft, which is primarily a software company. In order to generate profits, it primarily needs human capital; this business model is not capital intensive. Banks, on the other hand, need to raise large amounts of capital: bank deposits, bondsetc. And since assets on banks' balance sheets are traditionally characterized by relatively high liquidity, such assets can be valued at their real market value. This means that the bank balance sheet will be equivalent to the real market value of its assets, or coefficient 1.
One useful way to apply the price/book value metric is its Using the value of assets on the company's balance sheet for valuation purposes. Less liquid assets may be overvalued. During boom periods, book value rarely helps bargain hunters who like to buy securities at a low rate because most companies will not engage in transactions if the book value (net asset) ratio is 1. During periods of economic downturn or recession, P/B is more valuable because it helps investors hunt for bargain buys in extremely undervalued companies.
The P/B value may fall below unity in cases of liquid firms (banks, etc.). This usually happens when the market fears the destruction of the company's equity value. This can be caused by leverage, which is clearly demonstrated by the current financial crisis. As a rule of thumb, the more liquid a company's assets are, the closer its P/B ratio will be to the 1 mark, all other things being equal. The more profit a company can generate through its balance sheet assets, the higher the P/B ratio will be.
In conclusion, we would like to emphasize that there are no evaluation criteria that can reveal or at least try to reveal the whole truth, but even knowledge of the main pitfalls can save investors from making mistakes for which they will have to pay dearly.