Price-to-Earnings vs. Price-to-Book
Knowing how much to pay for an asset is a vital skill for the successful investor. Herein we introduce two metrics that approach the concept of valuation from two quite different perspectives: the price-to-earnings ratio (P/E) considers a company’s value to be in its ability to generate profit, while the price-to-book ratio (P/B) prizes a company’s chattels in excess of its charges. The distinction is akin to a landlord who could value his property portfolio in terms of the rent he receives, or in terms of how much he could obtain by selling his buildings.
We begin with the P/E, which is calculated by dividing the current share price by a company’s earnings (or post-tax profits) per share. It is said that earnings are like haggis: if you knew what went into them, you’d never touch them again. But for the sake of this article we will ignore all the accounting fallibilities. A lower P/E indicates a “cheaper” company: for example, at time of writing investors are paying £28 for every £1 made by Zoopla (ZPLA) last year, but just £10 for every £1 made by Royal Mail (RMG). Is a pound made delivering postcards from the Cotswolds less valuable than a pound made marketing the Cotswolds’ coveted cottages? This highlights a fundamental flaw in the P/E ratio – it takes no account of future growth. Rightly or wrongly, the market expects that Zoopla will be able to grow future earnings at a faster pace than Royal Mail, and so is therefore deemed as deserving of a higher multiple today.
That said, history casts its vote in favour of the P/E ratio: countless studies have shown that stocks with a lower P/E ratio on average, over the long run, outperform those on a higher ratio. One rationale for this is that the future has a propensity to surprise, and expensive companies with high expectations tend to have disappointing surprises, whereas cheap companies with low expectations often turn out to be not nearly as bad as feared.
Earnings can be highly volatile, as the world’s oil companies discovered in 2014. For cyclical companies, P/E ratios are usually highest at the bottom of the cycle (after low earnings), and lowest at the top of a cycle (following high earnings). The P/E ratio is also inappropriate for loss-making businesses – Vodafone made a loss in 2006; an investor using only the P/E ratio might conclude that Vodafone was worthless (the company today is worth over £60bn).
Turning to the price-to-book ratio, the book value of a company is everything that it owns (its assets: buildings, inventory, cash…) minus everything that it owes (its liabilities: loans, taxes, bills…). The P/B ratio divides the current share price by the book value per share. In theory, a deep-pocketed investor could purchase a company that trades with a P/B of less than one, close the business, sell all its assets, pay off its dues, and still walk away with more than the purchase amount. A while ago, this practice was referred to as asset-stripping.
The P/B ratio can miss opportunities, notably as it takes account neither of growth of assets nor of the return that the company makes on them. However again history has also smiled kindly on the use of P/B as a valuation tool, again with various studies showing companies with a low price-to-book value have a tendency over the long run to do better for an investor than those on a higher ratio.