Distinguishing Price-to-Earnings from Price-to-Book Ratios
Summary
The discussion separates three measures that can be confused when reading a valuation example: the price-to-earnings multiple, the price-to-book ratio, and return on equity. A market index value compared with book value gives a price-to-book ratio; it does not produce the earnings multiple. The latter requires earnings, and its reciprocal is the earnings yield.
The answer explains that earnings relative to book value correspond to return on equity, helping connect valuation multiples to the productivity of accounting capital. It also cautions that book value is an imperfect proxy for invested capital, especially for businesses whose value depends on brands or other intangible assets rather than physical assets. The example illustrates the arithmetic and its interpretation, but the contributors stress that these accounting ratios alone cannot capture the full differences among business models or determine what a company is worth.
Key ideas
- Price divided by book value is a price-to-book ratio, not a price-to-earnings multiple.
- The price-to-earnings multiple uses earnings, and its reciprocal is the earnings yield.
- Earnings relative to book value correspond to return on equity.
- Book value may be a weak measure of capital for businesses built on intangible assets.
- Valuation ratios provide limited insight into differences among business models.
Tags
Full text
# Calculating 'times earnings' - Intelligent Investor book question # Calculating 'times earnings' - Intelligent Investor book question I'm reading the Intelligent Investor and I came across a passage where Graham calculates the 'times earnings' of the DJIA. But is it wrong, or am I misreading it? > Since the market value of these issues is well above their book value—say, 900 market vs. 560 book in mid-1971—the earnings on current market price work out only at some 6 1⁄4%. (This relation- ship is generally expressed in the reverse, or “times earnings,” manner—e.g., that the DJIA price of 900 equals 18 times the actual earnings for the 12 months ended June 1971.) This must be very simple for you guys, but isn't 'times earnings' supposed to be 900/560 = 1.6? I'm wondering where that 18 came from (Please let me know if this question belongs in money.stackexchange.com) ## Answer by demully (score 1, accepted) https://quant.stackexchange.com/a/69151 Index = 900 (ie market price of equity) Book Value = 560 (ie accountant's estimate of the equity capital invested in the company) The 16x PE multiple (the reciprocal of the 6.25% "earnings yields") implies an EPS of 56.25. Which does indeed imply a "price/book value" of 1.6x as you say. It also implies a "return on equity" of 56.2/560 = 10.0%. This is an accounting ratio estimating the productivity of these assets. Intuitively, you should be prepared to pay more for a more productive asset than you would for a less productive asset. Hence Graham is the Bible for value investors, ie low P/E is good because it implies a good trade-off between P/B and ROE (equals E/B) Needless to say, reality has long been more nuanced than this. And the accounting "book" has become an ever less concrete measure of capital invested in a business, as businesses have become less physical-capital-intensive. The Graham approach struggles to differentiate between two identical businesses, one of whose brands is strong while the other's are weak. And it never ever pretended to know which of the Facebook versus Google models for attracting eyeballs to adverts were superior to the other. It never even pretended to know how to value either in the first place, neither being dependent on physical plant and equipment that declined in value through use, wear and tear... ## Answer by D Stanley (score 1) https://quant.stackexchange.com/a/69140 560 is the book value, not earnings. For earnings you'd have to find the earnings per share of each constituent and take the proper weighted total.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.