Book Value & Price-to-Book Ratio

Price-to-book ratio or P/B ratio, is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value. Book value is the shareholders' equity (assets minus libilities) divided by the total number of outstanding shares. The calculation is often done using 'per share' values for both price and book.
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware this varies a fair amount by industry. Industries that require higher infrastructure capital (for each dollar of profit) will usually trade at P/B much lower than the P/B of (e.g.) consulting firms.
This ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately. For companies in distress the book value is usually calculated without the intangible assets that would have no resale value. In such cases P/B should also be calculated on a 'diluted' basis, because stock options may well vest on sale of the company or change of control or firing of management.

See Also: Value Investing , P/E Ratio , Active Portfolio Management , BV in Stock Market

P/E RATIO

The P/E ratio of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is used to measure how cheap or expensive its share prices is. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. It is a valuation ratio included in other financial ratios.


The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The EPS used can also be the "diluted EPS" or the "comprehensive EPS"

For example, if stock A is trading at $24 and the Earnings per share for the most recent 12 month period is $3, then the P/E ratio is 24/3=8. Stock A said to have a P/E of 8 (or a multiple of 8). Put another way, you are paying $8 for every one dollar of earnings.

It is probably the single most consistent red flag to excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and opportunities. By relating price and earnings per share for a company, one can analyze the market's valuation of a company's shares relative to the wealth the company is actually creating.

One reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods may be dangerous. To have faith in a comparison of P/E ratios, one should compare comparable stocks.

See Also: Value Investing , Active Portfolio Management , Price-to-Book Ratio , Book Value in Stock-Market ,

Active Portfolio Management

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing - buying diversified portfolios of all the securities in an asset class - is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds.

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments.These decisions, often referred to as market timing as investors try to reallocate between equities and bonds (see FIXED INCOME) in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements .
Then there is security selection - picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.


Active investing involves being 'overweight' in securities and sectors that you believe to be undervalued and 'underweight' in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market.Compared to passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (see TECHNICAL ANALYSIS, VALUE INVESTING and GROWTH INVESTING). And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.

See Also: Value Investing , Price-to-Book Ratio , P/E Ratio , BV in Stock Market