Why Is PB Ratio More Relevant For Banks Than PE Ratio?

The price-to-book (P/B) ratio and price-to-earnings (P/E) ratio are two commonly used valuation metrics in the financial industry. While both ratios can provide valuable insights into a company's financial health and prospects, the P/B ratio may be more relevant for banks than the P/E ratio. 

This document will explore why this is the case and discuss the benefits and drawbacks of using the P/B ratio as a valuation metric for banks. Firstly, let us understand conceptually, what the P/B ratio and P/E ratio are.

What is the P/B ratio?

The price-to-book (P/B) ratio is a valuation many metric investors use to compare a company's market capitalisation to its book value. 

The P/B ratio can easily be calculated by dividing the stock price at a current value per share by the company's book value per share (BVPS). This ratio provides insight into how the market values a company's assets relative to its market price.

It is important to note that the market value of equity is often higher than a company's book value. The market values a company's intangible assets, such as brand recognition and intellectual property, which may not be reflected in its book value. 

As a result, a high P/B ratio may indicate that the market has high expectations for the company's future growth and profitability.

Value investors often use the P/B ratio to identify potential investment opportunities. A P/B ratio under 1.0 is generally considered a solid investment by value investors since it suggests the stock trades at a discount to its book value.

However, it is essential to note that a good P/B ratio is relative to the company and its industry. Comparing the P/B ratio of a technology company to that of a manufacturing company may not provide helpful insights since their business models and assets may differ significantly.

What is the P/E ratio?

The price-to-earnings (P/E) ratio is a valuation metric used to measure a company's current share price relative to its earnings per share (EPS). This ratio is also referred to as the price multiple or earnings multiple. Investors and analysts use P/E ratios to compare companies' relative values on an apples-to-apples basis, as well as to compare a company against its historical performance or to compare markets over time.

P/E ratios are projected on either a trailing (backwards-looking) or forward (projected) origin. A high P/E percentage may imply that a company's stock is overvalued or that stakeholders expect high future growth rates. 

However, companies with no earnings or are losing money don't have a P/E ratio as there is nothing to put in the denominator. In practice, two types of P/E ratios are commonly used: forward and trailing P/E ratios. 

A forward P/E ratio is based on projected earnings for the upcoming year, while a trailing P/E ratio is based on the past 12 months' actual salaries. Both types of P/E ratios have their advantages and disadvantages, and analysts should consider both when making investment decisions.

Differences between the P/B ratio and the P/E ratio

It is essential to understand the differences between the P/B and P/E ratios. The P/B ratio compares a company's market value to its book value, which is the value of its assets minus liabilities. A P/B ratio below 1 suggests that the company's stock is trading at a discount to its book value, while a P/B ratio above 1 implies that the company's stock is trading at a higher value than its book value.

The P/E ratio, on the other hand, compares a company's current stock price to its earnings per share (EPS). A higher P/E percentage suggests that investors are willing to pay more for each dollar of revenue the company generates. This could indicate that the company is expected to grow its earnings. A lower P/E ratio could imply that investors have lower growth expectations for the company.

Which ratio is the more commonly used valuation metric in the banking industry?

When it comes to banks, the P/B ratio may be more relevant than the P/E ratio for several reasons.

• First, banks have a unique business model compared to other industries. They hold significant assets, such as loans, which generate interest income over time. They also have significant liabilities, such as deposits, which they use to fund their operations. Due to this business model, a bank's book value can be a more reliable indicator of its financial health than its earnings.
• Second, banks tend to have more volatile earnings than other industries. The banking industry is subject to various economic factors, such as interest rates, inflation, and credit risk. These factors can cause a bank's earnings to fluctuate significantly yearly. As a result, using the P/E ratio to value a bank's stock can be less reliable than using the P/B ratio.
• Third, banks often have large amounts of goodwill on their balance sheets. Goodwill is an intangible asset that represents the premium paid for an acquisition over the fair value of the acquired company's assets. Goodwill can inflate a bank's book value and its P/B ratio. However, since goodwill is an intangible asset, it generates no earnings. Using the P/E ratio to value a bank's stock may not accurately reflect its actual value.

Despite the advantages of using the P/B ratio to value bank stocks, there are some drawbacks to consider.

• One potential drawback is that the P/B ratio does not consider a bank's future earnings potential. While the P/B balance can help assess a bank's current financial health, it may not provide insights into its growth prospects. This can make it difficult for investors to determine if a bank's stock is undervalued or overvalued based solely on its P/B ratio.
• Another potential drawback of using the P/B ratio is that changes can influence accounting standards. For example, if a bank changes its accounting policies, it could significantly change its book value, which could impact its P/B ratio. This means that investors need to stay current on changes in accounting standards and how they may affect a bank's valuation.

Conclusion

Despite these drawbacks, many investors still prefer using the P/B ratio to value bank stocks. One reason is that it provides a simple and easy-to-understand metric for assessing a bank's financial health. Banks hold significant assets on their balance sheets in the form of loans and securities used to generate income. Therefore, the P/B ratio, which compares a bank's market capitalisation to its book value, provides a better picture of its financial strength and asset quality than the P/E ratio, which focuses on earnings. 

Additionally, the P/B ratio can help investors identify undervalued banks and make informed investment decisions. As such, investors interested in the banking sector should consider the P/B ratio as a crucial valuation metric.

Note: To help plan your trading activities and investment strategies, find here the NSE Holidays 2023, BSE Holidays 2023, MCX Holidays 2023, and Muhurat Trading 2023. Also see here to know more about the stock market timings.

Disclaimer

The investment options and stocks mentioned here are not recommendations. Please go through your own due diligence and conduct thorough research before investing. Investment in the securities market is subject to market risks. Please read the Risk Disclosure documents carefully before investing. Past performance of instruments/securities does not indicate their future performance. Due to the price fluctuation risk and the market risk, there is no guarantee that your personal investment objectives will be achieved.