Owning Stocks

Market Value Ratios

While return and growth ratios are measures of a company's fundamental value, and therefore the value of its stocks, the actual stock price is affected by the market. Investors' demand can result in underpricing or overpricing of a stock, depending on its attractiveness in relation to other investment choices or opportunity cost.

A stock's market value can be compared with that of other stocks. The most common measure for doing so is the price-to-earnings ratio, or P/E. Price-to-earnings ratio is calculated by dividing the price per share (in dollars) by the earnings per share (in dollars). The result shows the investment needed for every dollar of return that the stock creates.

P/E = price per share ÷ earnings per share

For Microsoft, for example, the price per share is around $24, and the EPS is $1.70, so the P/E = 24.00/1.70 = $14.12. This means that the price per share is around fourteen times bigger than the earnings per share.

The larger the P/E ratio, the more expensive the stock is and the more you have to invest to get one dollar's worth of earnings in return. To get $1.00 of Microsoft's earnings, you have to invest around $14. By comparing the P/E ratio of different companies, you can see how expensive they are relative to each other.

A low P/E ratio could be a sign of weakness. Perhaps the company has problems that make it riskier going forward, even if it has earnings now, so the future expectations and thus the price of the stock is now low. Or it could be a sign of a buying opportunity for a stock that is currently underpriced.

A high P/E ratio could be a sign of a company with great prospects for growth and so a higher price than would be indicted by its earnings alone. On the other hand, a high P/E could indicate a stock that is overpriced and has nowhere to go but down. In that case, a high P/E ratio would be a signal to sell your stock.

How do you know if the P/E ratio is "high" or "low"? You can compare it to other companies in the same industry or to the average P/E ratio for a stock index of similar type companies based on company size, age, debt levels, and so on. As with any of the ratios discussed here, this one is useful in comparison.

Another indicator of market value is the price-to-book ratio (P/B). Price-to-book ratio compares the price per share to the book value of each share. The book value is the value of the company that is reported "on the books," or the company's balance sheet, using the intrinsic or original values of assets, liabilities, and equity. The balance sheet does not show the market value of the company's assets, for example, not what they could be sold for today; it shows what they were worth when the company acquired them. The book value of a company should be less than its market value, which should have appreciated over time. The company should be worth more as times goes on.

P/B = price per share ÷ book value of equity per share

Since the price per share is the market value of equity per share, the P/B ratio compares the current market value of the company's equity to its book value. If that ratio is greater than one, then the company's equity is worth more than its original value, and the company has been increasing its value. If that ratio is less than one, then the company's current value is less than its original value, so the value has been decreasing. A P/B of one would indicate that a company has just been breaking even in terms of value over the years.

The higher the P/B ratio, the better the company has done in increasing its value over time. You can calculate the ratio for different companies and compare them by their ability to increase value.

Figure 15.5 "Ratios and Their Uses" provides a summary of the return, growth, and market value ratios.

Figure 15.5 Ratios and Their Uses

Ratios can be used to compare a company with its past performance, with its competitors, or with competitive investments. They can be used to project a stock's future value based on the company's ability to earn, grow, and be a popular investment. A company has to have fundamental value to be an investment choice, but it also has to have market value to have its fundamental value appreciated in the market and to have its price reflect its fundamental value.

To go back to Keynes's analogy: it may take beauty to win a beauty contest, but beauty has to shine through to be appreciated by a majority of the judges. And beauty, as you know, is in the eye of the beholder.