[MUSIC PLAYING] In the stock market, investors and analysts both need a way to measure the relative value of organizations. They do this through a couple of ratios. One of them is the price-earnings ratio. And the other is the market-to-book ratio.
First, let's take a look at the P/E ratio. In stock trading, the price-to-earnings ratio, or the P/E ratio, or simply the multiple, is the measure of the market price of that share relative to its annual earnings per share.
The P/E ratio is calculated by dividing the market price per share by the annual earnings per share. This ratio is widely used in valuation as a guide to the relative values of companies.
If a P/E ratio is higher, it means the investors are willing to pay more for each unit of current income, so the stock is more expensive than one with a lower P/E ratio.
Let's look at an example. Here is a screen clipping of a quote from Yahoo Finance for Apple Computer. Notice it's selling for over $324 a share. That's pricey.
But if we look here, we see that the P/E ratio, the price-earnings ratio, or the multiple, is 25.75. Just underneath that, we see the earnings per share is $12.60 per share annually.
So if we take that price of $324.34 per share and divide it by the earnings per share of $12.60, we get the P/E ratio multiple of 25.75. So if we're investing in tech stocks, we could compare that multiple with other companies in the industry.
The second ratio that is used to capture market value is the price-to-book ratio. This ratio is used to compare the company's current market price to its book value. The price-to-book book ratio is calculated by taking the share price and dividing it by the book value per share.
It can vary a lot by industry. In industries that require more infrastructure capital will usually trade at price-to-book ratios that are lower than consulting firms in the service industry. This ratio is the most commonly used to compare banks, because most assets are liabilities of banks are usually valued at market value.
A higher price-to-book ratio implies that investors expect management to create more value from their assets. Considering all of the things being equal, price-to-book though don't directly provide any information on the ability of a firm to generate profits or cash for shareholders. However, it does give us some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately.
Let's take a look at an example. Here we are back with Apple Computer and the information that we got from Yahoo Finance. Here we see the price-to-book ratio is 15.89. And that's taken by dividing the price that we see of $324.34 by the book value of the firm's total capitalization.
The price per share for that is not shown here, but we do see the total capitalization as $1.42 trillion. This projects the relative value of the firm.
Here's some key points to remember. The price-earnings ratio, also called the P/E ratio or the multiple, it is the market price per share divided by the annual earnings per share. It is a widely used ratio evaluation of multiple organizations. And it's used as a guide for the relative values of companies.
As an example, a higher P/E ratio means that investors are paying more for each unit of current income. So the stock is more expensive than one with a lower P/E ratio.
The second ratio is the price-to-book ratio. It's calculated by dividing the company's current share price by the book value per share. A higher price-to-book implies that investors expect management to create more value from the given set of assets, all other things being equal.
This is Dr. Bob Nolley. And I look forward to seeing you in the next lesson.