The key financial ratios
Key figures sum up a company in a few values. Within one industry they're useful. If you use them to compare companies from different industries, they lead you astray.
Learning objective: After this lesson you can compare company figures sensibly within an industry instead of misreading them across industries.
The P/E ratio compares the share price with the profit per share. A P/E of 20 means you're paying twenty times the annual profit. If profit stayed the same, the company would have earned back your purchase price after twenty years.
Price to Book and Substance
The P/B ratio compares the share price with equity per share according to the balance sheet. It's mainly useful for companies with a lot of tangible assets, such as banks or industrial groups, and of little use for companies whose value lies in software or a brand.
Equity Ratio and Dividend
The equity ratio shows how much of the company is really owned and how much runs on credit. The dividend yield shows how much dividend you get relative to the share price.
Comparing Within an Industry
One of the most important things about all key figures: compare them within one industry. A P/E of 12 is very low for a software company and quite normal for a steel group. Mixing up industries reliably gets you wrong answers.
Turn the P/E upside down and you get the earnings yield. A P/E of 20 corresponds to a 5 percent earnings yield. A simple growth model shows that a high P/E means either that investors expect a lot of growth or that they're content with a low return. So the P/E isn't a valuation. It sums up expectations.
Trailing and Forward P/E
There are two versions. The trailing P/E uses last year's actual profits, the forward P/E analysts' estimates, which are too optimistic on average. For companies whose profits swing with the economy, the trailing P/E misleads. At the peak of profits it looks low, in the trough high, although it's exactly the other way round. A chemicals group with a P/E of 8 at the height of a boom is often more expensive than it looks. Versions that average profit over several years help, such as the Shiller P/E.
Reliability of Price to Book
How meaningful the P/B is depends on the accounting. What a company builds itself, such as a brand or software, usually isn't on the balance sheet at all. What it buys in shows up as goodwill. Two companies that are economically similar can therefore have very different P/B ratios, depending on whether they built or bought.
Summary
- A P/E sums up expectations, it isn't a valuation.
- For companies with swinging profits, the P/E looks deceptively low in a boom.
- Only compare key figures within one industry.
Did you get it?
What does a high P/E express?
High growth expectations or that investors are content with a low return. That doesn't automatically make the share expensive.
Why is the P/E tricky for companies with swinging profits?
At the peak of profits it looks low and in the trough high, although the situation is the other way round.
Why does the P/B say little for software companies?
Because self created assets like software or brands usually aren't on the balance sheet at all.
Check your understanding
Your task
A stock costs $50 and earnings per share are $4. Calculate the P/E ratio and the earnings yield. Then note which company in the same industry you would compare this number with, and why a comparison with a company from a different industry can lead to wrong conclusions.
Sources and further reading
- An NBER study documents that optimistically biased analyst earnings estimates are systematically linked to weaker subsequent returns for the affected stocks. View source ↗
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