2 essential tools every investor should know: P/E and P/B ratios

DDerek October 22, 2023 4:21 PM

In the world of investing, there are a few tools that are absolutely essential for any investor - whether you're a beginner or a seasoned pro. Among these, the Price to Earnings (P/E) ratio and the Price to Book (P/B) ratio stand out as two of the most important. They give you a quick snapshot of a company's financial health and can help you make informed investment decisions.

What is P/E ratio?

The P/E ratio, or Price to Earnings ratio, is a financial metric that measures the price you pay for each dollar of a company's earnings. In other words, it tells you how much investors are willing to pay per dollar of earnings.

To calculate the P/E ratio, you divide the market value per share (the price) by the earnings per share (EPS). For example, if a company's stock is trading at \$50 and its EPS is \$5, the P/E ratio is 10. This means investors are willing to pay \$10 for each dollar of earnings.

What is P/B ratio?

The P/B ratio, or Price to Book ratio, is another financial metric that compares a company's market value to its book value (the value of its assets minus liabilities). It gives you an idea of whether you're paying too much for what the company is actually worth.

To calculate the P/B ratio, you divide the market value per share by the book value per share. For example, if a company's stock is trading at \$100 and its book value per share is \$20, the P/B ratio is 5. This means you're paying \$5 for each dollar of book value.

How to use P/E and P/B ratios

Here are a few ways you can use these ratios in your investment strategy:

1. Value investing: Value investors look for stocks that are undervalued, or cheap compared to their intrinsic value. They would look for stocks with low P/E and P/B ratios, indicating that the stock is undervalued.
2. Growth investing: On the other hand, growth investors are less concerned with the current price and more focused on the company's future potential. They might be willing to pay a higher price (and hence a higher P/E or P/B ratio) for a company that is expected to grow rapidly.
3. Fundamental analysis: Both the P/E and P/B ratios are key metrics in fundamental analysis, which is a method of evaluating a company's intrinsic value by examining related economic and financial factors.

The P/E and P/B ratios are powerful tools that can help you make better investment decisions. While they're not the only tools you should use, they're a good starting point for any investor. Remember, investing is about more than just looking at numbers - it's about understanding the story behind those numbers. And these ratios can help you understand that story.