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Price/earnings ratio

Market prices incorporate all kinds of information. For example, the market prices for firms in a given industry

include average investor expectations about future earnings growth in that industry and required rates of return

for firms in that industry. This information is summarized in the Price-Earnings (P/E) Ratio, computed as (Price

per share ÷ Earnings per share). In general, industries in which expected future earnings growth is expected to

be high are characterized by high P/E ratios. An example is any kind of high technology industry such as

software development or pharmaceuticals. Conversely, in industries where expected future earnings growth is

low, P/E ratios are low. Examples of these industries are any traditional manufacturing business such as heavy


Rather than directly estimating growth rates and required rates of return, an investor can estimate the value of a

company’s shares by using the information in the P/E Ratios of similar companies, as follows:

Price = Earnings × P/E Ratio

Price/book (P/B) ratio

A favorite ratio among followers of the stock market is the price-to-book ratio, computed as total market value

of common equity total divided by book value of common equity. The price-to-book ratio reflects the

difference between the balance sheet value of a company and the company’s actual market value. A company’s

price-to-book ratio is almost always greater than one. This is because many assets are reported at historical cost,

which is usually less than market value, and other assets are not included in the balance sheet at all. In addition,

many intangible economic assets, such as a reputation for superior products or customer service, are not

recognized in the balance sheet.

A company will have a P/B ratio greater than one if investors think that the managers of the company have used

funds invested in the company in the past in effective ways. A good way to think of this is that a company’s...