The basic principle behind market-oriented company valuation is that the investor’s subjective judgement should be partly replaced by the objectivity of the market (market price). In this context, it is particularly important to bear in mind the words of the father of fundamental analysis, Ben Graham.
“Price is what you pay; value is what you get.”
This is intended to illustrate that there is a difference between the price of a company (share price) and its value. (i.e. price ≠ value)
P/E ratio (price-to-earnings ratio)
The P/E ratio – often referred to by the Anglo-Saxon term ‘PE’ (price-earnings ratio) – is the best-known indicator in fundamental analysis and can be interpreted as follows:
How many years will it take for the company to generate the value of its shares as profit?
A low P/E ratio can serve as a good guide for investors to gauge a company’s potential for share price appreciation. It is simple to calculate and practical, although it does not take earnings growth into account. A high P/E ratio may, for example, be justified if a company is experiencing above-average earnings growth. Similarly, a low P/E ratio for a company with slow profit growth does not necessarily indicate that it is undervalued.
P/E ratio = share price / earnings per share
Calculation example
The price of a share is EUR 33.30. The company generated a profit of EUR 2.24 per share in the past financial year.
P/B ratio (price-to-book ratio)
The P/B ratio indicates the ratio of the market value of equity on the stock exchange (price) to the value of equity as shown in the balance sheet (book value). It provides a very static approach to valuing a company and does not take into account the earnings situation or profit growth. For growth stocks (e.g. high-tech shares), the price-to-book ratio is not particularly meaningful and yields only sub-optimal results.
The higher the P/B ratio, the more expensive the share. A P/B ratio of less than 1 is a special case. Theoretically, it would be possible to buy the company on the stock market for less money than it is worth according to the balance sheet. This could make the share a takeover target.
P/B ratio = share price / book value per share
Calculation example
The price of a share is EUR 42.62. According to the balance sheet, the book value per share is calculated as EUR 10.21. This results in a price-to-book ratio of 4.17.
Author
Günther Kornfellner, CFA, CAIA
Derivate Trader, Bybit EU