Price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and price-to-sales (P/S) ratio are frequently used indicators in the relative valuation method. We talked about the P/E ratio in the last chapter. Now, let's move on to the P/B ratio and P/S ratio.

1. P/B ratio

Definition

The P/B ratio is a firm's stock price per share to its book value per share. The easiest way to calculate it is to divide the total market value by net assets.

Last time, we discussed the three types of P/E ratios: static, Trailing Twelve Months (TTM), and forward P/E ratios. The P/B ratio is easier. Generally, a listed firm's Generally, a listed firm's P/B ratio is calculated based on the net assets disclosed in the latest financial report.

Take Company A as an example. Assume Company A’s stock closed with a market capitalization of $100 billion and has $20 billion in net assets, according to its latest 2022 quarterly report. Then the P/B ratio of company A is 100/20 = 5×.

However, if the company manages to increase its net assets by raising more money, or reduce its net assets by paying dividends after it issues the latest financial report, we need to adjust the figure accordingly to calculate the latest P/B ratio.

What companies does the P/B ratio apply to?

We mentioned that the P/E ratio mainly applies to companies with stable returns. In contrast, the P/B ratio works better for companies with unstable earnings, which means that the company's performance shows no apparent long-term trend.

Often, unstable corporate earnings can be identified in cyclical industries, such as oil, natural gas, coal, non-ferrous metals, steel, and airline.

That's because their profits are tied to resource prices or business cycles. When resource prices rise, most producers will earn more. Otherwise, if resource prices fall, most producers will face fewer returns or losses.

Resource prices swing cyclically, and so does the profitability of companies in cyclical industries. However these firms generally have a stable net assets value, making the P/B ratio a better indicator of corporate valuation.

How to assess the P/B ratio valuation?

After calculating a company's valuation with the P/B ratio, how do we evaluate the results? We can start with three dimensions.

We discussed the first two dimensions last time about the P/E ratio valuation, which compares the number with the industry average and the company's past valuation.

The third dimension is about the industry, that is, the price trend of resources. If resource prices keep rising in a booming sector, the valuation of relevant stocks could be more expensive. The valuation may be lower if resource prices drop when the industry goes downhill.

2. P/S ratio

After talking about the definition, application, and evaluation of the P/B ratio, let's take a look at the P/S ratio.

Definition

The P/S ratio is the ratio of stock price to sales per share. We can simply divide the total market capitalization by total revenue to calculate it.

Let's say Company A earns $5 billion in revenue, then its P/S ratio based on its 2021 performance is 100/5 = 20×.

Like the P/E ratio, the P/S ratio can also be divided into static, Trailing Twelve Months (TTM), and forward P/S ratios. And their calculation is similar to that of the P/E ratio.

What companies does the P/S ratio apply to?

The P/S ratio is mainly used for fast-growing companies that have yet to gain profits.

Many companies in emerging sectors develop rapidly, with rising revenue in the early stages. But they may shell out their earnings to increase their market share. Some capital markets, such as the US market, allow such money-losing companies to go public. With public financing, these companies may turn profitable as they grow.

For instance, most companies didn't have returns when the internet industry was on the horizon. However many of them expanded their market share through heavy marketing campaigns and started to profit.

The development of the electric vehicle industry in recent years echoes this pattern. EV start-ups need high sales and economies of scale to recoup their initial investment. For example, Tesla went through years of loss before it turned a profit in 2020. So for a company yet to have returns, we usually use the P/S ratio to measure its valuation.

How to assess the P/S ratio valuation?

The criteria are similar to that of the P/E ratio. In particular, comparing the P/S ratio of a company with that of its peers is the most effective way since the value varies significantly across industries.

In addition, the valuation is subject to the revenue growth rate. Although there is no quantitative metric as PEG for the P/S ratio, the principle is the same: the faster a company's revenue grows, the higher the valuation.

Now we’ve covered all three relative valuation indicators. In the next chapter, we’ll move on to other important factors affecting valuation.