When evaluating a company, investors often look at a company's price-to-earnings ratio (P/E) and its market-to-book ratio, often called price-to-book ratio (P/B.) P/E is the ratio of annual earnings to stock price. P/B is the ratio of stock price to book value. "Book value" has several definitions, but the one that best applies here is "the value of a company's assets in liquidation." While both ratios are widely studied, disagreement remains about how reliably they reveal a stock's value.
Momentum vs. Growth
Investors divide into momentum investors and value investors. A momentum investor sees a stock with increasing upward price momentum that consistently outperforms the market as a preferred investment. That these stocks tend to have high P/Es is a consequence of success. The value investor, on the other hand, seeks stocks with low P/Es that may be undervalued for reasons irrelevant to the company's real worth.
The Value Significance of Low P/Es
Investors look for other indications that a stock's low P/E indicates a bargain. An uninterrupted history of dividends, and dividends that exceed the market average in a company's financial sector, such as utility companies or automobile manufacturers, are both favorable indicators. It may be as well that a stock's low P/E is relatively high with respect to the P/Es of other stocks in the same sector, which happens when an investment sector falls out of favor with investors as investors saw with residential construction stocks following the housing market crash of 2008-9.
The Momentum Significance of Low P/Es
A stock with a low P/E only rarely has superior price performance that attracts positive attention from momentum investors. However, it can happen. Following the housing market crash, Pulte, one of the top three U.S. home-builders, had a negative P/E for several years, and it was still losing money in October 2011. However, over the next six months, the stock price doubled, significantly outperforming the general market. While a low P/E usually warns off momentum investors, the price momentum told a different story. Clearly, by April 2012, Pulte's still-low P/E and increasing price momentum signaled a buy to value and momentum investors alike. Confirming this, the stock price rose by 400 percent from October 2011 to October 2013.
Low Price to Book Ratio
For value investors, a low price-to-book ratio is another indication that a stock may be undervalued. Low P/Bs indicate investor skepticism about management's ability to generate positive cash-flows. If this skepticism is misplaced, the stock is likely a bargain.
Significance of a Stock with High P/E and Low P/B
A company with a high P/E and a low M/B would be a rare combination, but, like Pulte's stock in 2011, this unlikely pairing of ratios could happen. For example, a company emerging from an era of severe mismanagement could be making strong gains in credibility among knowledgeable investors that increase its stock price before this is reflected in quarterly earnings reports. If the previous situation were bad enough, early in the company's rejuvenation there may be a moment where the P/B, although substantially improved, still remains low. This somewhat strange combination of ratios may indicate a still undervalued stock that will enjoy a substantial price run-up going forward.
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