A stock that is priced at ₹500 and has earnings of ₹25 per share has a price-to-earnings (P/E) ratio of 20. If the book value is ₹250 per share the price-to-book (P/B) ratio is 2. These two numbers describe the price but one is based on what the company earns and the other is based on what the company owns.
The question of whether to use the P/E ratio or the P/B ratio depends on what kind of company’s being valued. The P/E ratio works best for companies that have profits. The P/B ratio works best for companies that are mostly made up of assets like banks. Neither of these numbers tells you if a stock is cheap. Both need to be compared with companies with the companys own history and with how good the business is.
What each ratio measures
| Metric | Formula | What it shows |
|---|---|---|
| P/E ratio | Share price divided by earnings per share (EPS) | How rupees the market pays for each rupee of annual profit |
| P/B ratio | Share price divided by book value per share | How the market values the company against the assets on its balance sheet |
| Return on equity (ROE) | Net profit divided by shareholders equity | How much profit the company earns on the money shareholders have invested |
Key differences between P/E and P/B
| Feature | P/E ratio | P/B ratio |
|---|---|---|
| Based on | Earnings, which come from the income statement | Book value, which comes from the balance sheet |
| Suits | Companies that are profitable and have stable or growing earnings | Banks, insurers and other businesses with lots of assets |
| Weak spot | It does not make sense if earnings are negative very small or inflated by one-time gains | It misses the value of businesses that do not have a lot of assets like software companies or brands |
| Sensitive to | Changes in profit and how expenses are accounted for | How assets are valued and how write-offs are handled |
| Typical comparison | With other companies in the same industry with the companys own history and with the overall market | With other companies and with the companys return on equity |
How the two ratios connect
The P/B ratio is equal to the P/E ratio multiplied by the ROE. In the example given, a P/E of 20 and an ROE of 10% (earnings of ₹25 on a book value of ₹250) result in a P/B of 20 × 0.10 = 2. A company with a ROE can support a higher P/B than a company with a low ROE. A high P/B may just mean that the company is very profitable.
How to read high and low values
| Reading | What it may indicate | What else to check |
|---|---|---|
| Low P/E | The stock may be. Earnings may be expected to drop | Are the profits one-time, cyclical or shrinking? |
| High P/E | The market may expect rapid growth or the stock may be overpriced | What is the growth rate behind the earnings and what is the P/E of companies? |
| Low P/B | The stock may trade below the value of its assets or the assets may not be strong | How strong are the assets, how high is the ROE and are there loans or write-offs? |
| High P/B | The company may earn returns on its equity or the expectations may be too high | What is the ROE what is the growth outlook and how much does the company rely on intangible value? |
A low ratio does not mean a stock is a deal and a high ratio does not mean it is expensive. A stock can look cheap for years because the business is not doing well. This pattern is often called a value trap.
Which ratio fits which sector
| Type of business | Useful ratio | Reason |
|---|---|---|
| Banks and financial companies | P/B along with ROE | Their assets and liabilities are mostly financial so book value reflects the business well. |
| Stable consumer and technology companies | P/E | Earnings are steady. Show the value that the balance sheet does not capture. |
| Cyclical companies like metals and commodities | P/B or P/E using earnings through a cycle | Earnings change a lot so a single year’s P/E may not be reliable. |
| Companies with losses | P/B or other measures | The P/E has no meaning if earnings are negative. Other measures such as P/B or sales-based ratios are used instead. |
Trailing and forward P/E
The trailing P/E uses the 12 months of reported earnings. The forward P/E uses earnings expected for the 12 months. A forward P/E depends on forecasts that may be too high or too low. It is best to look at both numbers
What investors should take from this
Valuation ratios are tools that help point to companies that need attention. How to interpret them depends on the sector the company’s growth and its return on equity. Comparing a stock to others in the business and to its own history gives a more accurate picture than comparing across different industries.
Kuvera offers mutual funds, including index funds. The index factsheets provided by index providers list the P/E and P/B of each index. This shows how the overall market is valued.
Frequently Asked Questions
1. What is the difference between P/E and P/B ratio?
P/E compares the share price with earnings per share. P/B compares it with book value per share.
2. Which ratio is better for banks?
P/B, along with ROE is more common for banks. Their balance sheets show the business better than earnings
3. Is a P/E ratio always good?
No. A low P/E might mean the stock is undervalued or it might mean the market expects earnings to drop.
4. How are P/E, P/B and ROE related?
P/B is equal to P/E multiplied by ROE.
5. Can P/E be used for companies with losses?
Not really. Negative earnings make the P/E ratio not useful. Other measures like P/B or sales-based ratios are used instead.
Investments in securities are subject, to market risks. Read all documents carefully.
