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In the stock market, investors and analysts both need a way to measure the relative value of organizations. They do this by utilizing a couple of ratios:
The PE ratio is calculated by dividing the market price per share by the annual earnings per share.
This ratio is a widely used valuation multiple used as a guide to the relative values of companies. If a PE ratio is higher, it means that investors are willing to pay more for each unit of current net income, so the stock is more expensive than one with a lower PE ratio.
IN CONTEXT
Here is a screen clipping of a quote from Yahoo Finance for Apple Computer.
Notice it is selling for $324.34 a share, which is rather pricey. However, we can see that the price earnings ratio, or the multiple, is 25.75. Just underneath that, we see the earnings per share is $12.60 annually. If we take that price of $324.34 divided by the earnings per share of $12.60, we get the PE ratio, the multiple, of 25.75.
So, if we are investing in tech stocks, we can compare that multiple to 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 ratio is calculated by taking the share price and dividing by the book value per share.
This ratio can vary a lot by industry. Industries that require more infrastructure capital will usually trade at price to book ratios that are lower than consulting firms or firms in the service industry. This ratio is most commonly used to compare banks, because most assets and 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. All other things considered equal, price to book ratios do not directly provide any information on the ability of the firm to generate profits or cash for shareholders. However, it does provide some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately.
IN CONTEXT
Here again is Apple Computer and some information from Yahoo Finance.
Here we can calculate a price to book ratio of 15.89 by dividing the price of $324.34 by the book value of the firm's total capitalization. The book value per share is not shown here but we do see the total market capitalization at $1.42 trillion. This projects the relative value of the firm.
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