The key financial ratios
Ratios compress a company into a handful of numbers. They're useful for comparing within an industry and misleading the moment you use them across industries.
The P/E ratio compares the price against earnings per share. A P/E of 20 means you're paying twenty times annual earnings. At constant earnings, you'd break even after twenty years.
Price-to-book compares the price against book equity per share. It suits asset-heavy companies like banks or industrials well, and companies whose value sits in software or brand poorly.
The equity ratio shows how much of the company is actually its own versus financed. Dividend yield shows how much payout you get relative to the price.
The most important sentence about all of them: compare ratios within an industry. A P/E of 12 is cheap for a software firm and normal for a steel mill. Mix industries, and you'll reliably get wrong answers.
The P/E ratio is the inverse of earnings yield and can be expressed from the growth model as P/E = payout ratio / (r − g). It follows that a high P/E expresses either high expected growth or a low required return. It's therefore not a valuation, it's a summary of expectations.
A distinction is needed between trailing and forward variants. Trailing P/E uses realized earnings; forward P/E uses analyst estimates, which are systematically optimistic. For cyclical businesses, the trailing variant produces a paradox: at peak earnings the P/E looks low, and at trough earnings it looks high, even though valuation is actually the opposite in each case. Cyclically adjusted variants using multi-year averages address this.
For price-to-book, informational value depends on accounting treatment. Internally generated intangible assets are mostly not capitalized, while acquired ones show up as goodwill. Two economically similar companies can therefore show sharply different price-to-book ratios, depending on whether they built their substance themselves or bought it.
Summary
- A P/E summarizes expectations, it doesn't value.
- For cyclical companies, the P/E looks deceptively low at peak earnings.
- Compare ratios only within the same industry.
Did you get it?
What does a high P/E express?
High growth expectations or a low required return, not automatically an expensive stock.
Why is the P/E tricky for cyclical companies?
It looks low at peak earnings and high at trough earnings, even though the actual situation is reversed.
Why is price-to-book uninformative for software companies?
Because internally generated intangible assets mostly don't show up on the balance sheet.