Valuation Ratios

The exam covers two valuation ratios: P/E and P/B. Each highlights a different question about how the market is pricing a stock.

What Does the Price-to-Earnings (P/E) Ratio Show?

P/E is the most widely used valuation metric for stocks. It shows how much investors are willing to pay for each dollar of earnings.

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

How is EPS itself calculated? EPS = (Net Income - Preferred Dividends) / Common Shares Outstanding. Preferred dividends are subtracted first because that income belongs to preferred shareholders, not common shareholders.

How Do You Calculate P/E in an 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

How Do You Interpret a High or Low P/E?

• Higher P/E: investors expect higher future growth (or the stock may be overvalued)
• Lower P/E: investors expect lower growth (or the 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.

How Does a Stock Split Affect the P/E Ratio?

• A stock split (for example, 2-for-1 or 3-for-1) increases the number of shares outstanding and cuts both the market price and EPS by the same proportion
• Because the price and EPS move together, the P/E ratio itself does not change
• Example: a $50 stock with EPS of $2.50 has a P/E of 20 ($50 / $2.50). After a 2-for-1 split, the price falls to $25 and EPS falls to $1.25, so the P/E is still $25 / $1.25 = 20

What Does the Price-to-Book (P/B) Ratio Show?

P/B compares the market's valuation of a company to its accounting (book) value.

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

• Book value per common share = (Total Assets - Total Liabilities - Preferred Stock) / Common Shares Outstanding
• Preferred stock comes out first because preferred holders have a priority claim on assets ahead of common shareholders. When a company has no preferred stock outstanding, the formula reduces to Shareholders' Equity / Common Shares Outstanding

How Do You Calculate P/B in an 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

How Do You Interpret P/B Above or Below 1.0?

• P/B > 1.0: the market values the company above its book value (common for profitable companies)
• P/B < 1.0: the 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, so a company's true worth may differ significantly from it. P/B below 1.0 could mean the stock is a bargain or that the company is in trouble; context matters.

How Do the Valuation Ratios Compare?

What Should You Check on Exam Day?

• P/E is meaningless when earnings are negative; check for that before trusting the ratio.
• EPS = (Net Income - Preferred Dividends) / Common Shares Outstanding; do not forget to subtract preferred dividends.
• A stock split does not change the P/E ratio; price and EPS adjust by the same proportion.
• Neither a high P/E nor a low P/B is automatically good or bad; both need a peer or historical comparison.
• Book value is historical-cost accounting, not current market value.