U.S.-based Apple, Inc. trades on the NASDAQ Stock Exchange with a share price of around US$544 as of February 14, 2014. That price sounds expensive, but is it? How can both novice and experienced investors tell if they’re overpaying for a stock or getting a bargain? Price Ratios provide one way to begin to solve the puzzle. Unlike performance indicators found in corporate financial statements, price ratios take into account the share price that investors are willing to pay for a stock. A price ratio uses share price as the numerator in an equation with a variety of fundamental measures as the denominator. The result is expressed in decimal or percentage form.

Valuing Stocks

Price purists would argue that a product is worth whatever a buyer is willing to pay for it. Product purists argue a product’s true value depends on its fundamental characteristics. In the case of stocks, these characteristics include critical financial metrics such as earnings, growth of earnings over time, revenues, and the value of the company’s assets.

Price ratios for stock valuation essentially combine price with fundamentals. Investors can get an idea of how much they’re paying for a stock in relationship to different fundamental characteristics. Calculating these ratios involves dividing the current price per share by the value of a fundamental characteristic—like earnings, revenue, or book value. Financial websites spare you the task of digging into a company’s financial statements (balance sheet, income statement, and statement of cash flow) by publishing the ratios. However, to fully understand how to use a price ratio, it helps to understand the calculations. Here are some of the most popular valuation ratios that you will find.

Price Ratio is a combination of price and fundamentals. The calculation involves dividing the current price per share by the value of a fundamental characteristic such as earnings.

Price to Earnings Ratio (P/E)

The Price to Earnings (P/E) ratio is arguably the godfather of all financial ratios, providing the ultimate benchmark for many investors. A stock with a P/E of 10 means that the price of the stock is ten times its earnings, or trading at a multiple of 10. Here is the formula for the P/E ratio:

Price per Share
Earnings per Share (EPS)

Using Apple, Inc. (one of the most recognizable brands on the planet) as an example, on February 14, 2014 we find a price per share of US$544.63, and from most financial websites we find the latest EPS was US$40.32. Do the math and you get a P/E of US$13.50. So what does that mean? And how can you use a P/E to improve your trading returns?

First, one could argue that any number taken in isolation is relatively meaningless without comparison to other relevant measures. In the case of Apple, we can compare the P/E to the P/E for the U.S. S&P 500 Index of 17.9 and determine that despite its lofty price, Apple is actually cheap when seen through the prism of the larger market. We can also compare Apple’s P/E to that of other large Technology Sector companies, like Google, which has a P/E of 33.28. Again, Apple looks cheap but does that mean you should stay away from a stock with a high P/E like Google?

The answer depends on your investing strategy. There are a wide variety of approaches to trading stocks, but broadly speaking they can be grouped into two polar opposite schools of thought. One is represented by the phrase Buy Low, Sell High; the other, by the phrase Buy High, Sell Higher. Some investors are bargain hunters, looking only at stocks with values that exceed their share prices. As a benchmark, this school of investing prefers stocks with a P/E under 15. Investors looking for substantial future growth see a high P/E as a sign of market approval of a stock’s future potential, and a low P/E as market judgment that the stock is going nowhere.

It helps you determine if the P/E ratio is at a reasonable price when you compare ratios, such as comparing Apple shares P/E ratio to the S&P 500

Comparative P/E ratios alone are not enough to fully evaluate a P/E ratio. While the price per share is an objective measure, earnings per share require further investigation. Financial earnings can be inflated or deflated by one-time charges, such as the cost of an acquisition or the profit from a sale of assets; or by inflationary pressures driving up the price of the company’s goods. Earnings resulting from factors controllable by the company (such as sales and cost controls) are said to be “high quality” earnings.

Price to Sales (P/S)

Even with comparative P/Es, investors should not rely on this or any other measure taken alone. The Price to Sales (P/S) ratio tells investors how much they’re paying for each dollar of revenue that the company generates. A P/S of 10 says that you are paying 10 dollars for each dollar of revenue generated. Here is the formula for calculating the P/S:

Market Capitalization
Total Revenue

Apple’s current market capitalization (total shares outstanding multiplied by the price per share) is US$487.85 and total revenues were US$173.99, for a P/S of 2.8. Some investors like the P/S ratio simply because revenue is less susceptible to accounting manipulation than earnings are. In the abstract, a lower P/S means you are paying less for each dollar of revenue generated by the company. However, using the P/S as a comparative measure requires an “apples to apples” comparison, since a dollar generated by a high-margin company like Apple returns more profit than an equal dollar of revenue generated by a low-margin company. With that in mind, Apple’s P/S of 2.8 compares very favorably to the broader Technology Sector’s P/S of 7.50.

The Price to Sales ratio tells investors how much they’re paying for each dollar of revenue the company generates. Some investors use P/S ratio because revenue is less susceptible to accounting manipulation

Price to Book Value (P/B)

The Price to Book Value (P/B) ratio is a favorite of bargain-hunting investors because, in theory, it can identify a stock with a share price that is less than the value of the company’s assets. Here is the formula for the ratio:

Price per Share
Book Value per Share

Apple has a P/B of 3.75—US$544.63 divided by a book value per share of US$144.72. Calculating book value per share is somewhat complicated: dividing total shareholder equity by total shares outstanding (common stock). In theory, a P/B under 1.0 means the stock is trading for less than it is worth. In practice the calculation lumps tangible and intangible assets together. A better ratio (not commonly found on financial websites) is Price to Tangible Book Value, which subtracts intangible assets like goodwill. This is another ratio requiring comparison to similar companies as not all have substantial tangible assets, such as property, plant, and equipment (PPE).

Price to Book Value (P/B) ratio identifies a stock with a share price that is less than the value of the company’s asset.

Bottom Line

Price valuation ratios give investors a means to determine how much they’re paying for various fundamental aspects of a company at current share prices. How you use price valuation ratios depends on your investing philosophy and trading strategy. 

An investor with the mindset that the price of a given stock at a given point in time reflects the judgment of market participants and is a valid measure of a company’s worth can use price valuation to avoid stocks out of market favor. In contrast, if you believe markets can be irrational and inefficient, lower price valuation ratios can be used to find bargain stocks and higher valuation ratios could be used to avoid paying more than the stock is worth.

Summary:

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A P/E Ratio of 20 means the investor is paying 20 dollars for each dollar of earnings generated.

 

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The P/S provides the same measure for revenue generated.

 

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The P/B shows the investor the per-share cost for a company’s assets.

 

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Price valuation ratios must be compared to ratios for similar companies in the same industry or sector.

 

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No single ratio is sufficient to justify an investing decision.

 

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