Valuation Factors

Valuation ratios are used by fundamental analysts to determine whether a stock is overvalued, undervalued, or fairly priced. Most useful when compared to industry peers, the market average, or the company's historical values.

The exam covers two valuation factors: Price-to-Earnings (P/E) and Price-to-Book (P/B).

Price-to-Earnings (P/E) Ratio

The most widely used valuation metric for stocks. Shows how much investors are willing to pay for each dollar of earnings.

Formula: P/E = Market Price Per Share / Earnings Per Share (EPS)

P/E Worked Example

• Stock price: $60
• EPS: $4
• P/E ratio: $60 / $4 = 15
• Interpretation: Investors are willing to pay $15 for every $1 of this company's earnings

Interpreting P/E Ratios

• Higher P/E - investors expect higher future growth (or stock may be overvalued)
• Lower P/E - investors expect lower growth (or stock may be undervalued)
• Growth stocks typically have higher P/E ratios than value stocks
• P/E is meaningless if the company has negative earnings (losses)

Exam Tip: Gotchas

A high P/E does not automatically mean overvalued; it may reflect justified growth expectations. A low P/E does not automatically mean undervalued; it may reflect legitimate concerns. Always compare P/E to industry peers, not in isolation.

Price-to-Book (P/B) Ratio

Compares the market's valuation to the company's accounting (book) value.

Formula: P/B = Market Price Per Share / Book Value Per Share

• Book value per share = (Total Assets - Total Liabilities) / Shares Outstanding
  • Also equals Shareholders' Equity / Shares Outstanding

P/B Worked Example

• Stock price: $45
• Book value per share: $30
• P/B ratio: $45 / $30 = 1.5
• Interpretation: The market values this company at 1.5 times its book value (accounting value)

Interpreting P/B Ratios

• P/B > 1.0 - market values the company above its book value (common for profitable companies)
• P/B < 1.0 - market values the company below its book value (may indicate undervaluation or distress)
• Particularly useful for financial companies (banks, insurance) and asset-heavy industries
• Less useful for companies with significant intangible assets (technology, services)

Exam Tip: Gotchas

Book value is an ACCOUNTING measure based on historical cost, not market value. A company's true worth may differ significantly from book value. P/B below 1.0 could mean the stock is a bargain OR the company is in trouble; context matters.

Summary: Valuation Factors