 Hello and welcome to this session in which we would look at the price to book ratio as well as the price earnings ratio. Matter of fact I'm going to explain each one separately then we're going to combine them together and see what they tell us about the market price of a particular stock. Before I start I would like to remind you to check out my website farhatlectures.com specifically if you are a CPA candidate or an accounting student. On my website I do provide additional resources if you're a CPA candidate for your CPA preparation whether you are using Wiley, Glyme, Roger, Becker or any other course I don't replace those courses I wish I can but I can't what I do is I can be a useful addition to your CPA course also I have plenty of accounting audit tax as well as finance courses also please connect with me on LinkedIn if you haven't done so subscribe to my YouTube and connect with me on Instagram and Facebook as well. Let's start by looking at market to book ratio or to be more specific it's known as price to book ratio. How do we compute this ratio? Well simply put we're going to take the price of the share which is the market price of a share divided by the book value per share. Now there is a way to compute the book value per share and it's important to understand how the book value is computed because because I'm going to take this ratio and kind of bisect it a little bit the book value per share is the book value of the company what is the book value of the company we look at the company's balance sheet they have assets and they have liabilities plus equity what's going to happen is this assets minus liabilities equal to equity so this is basically the equity is what's left over we'll take the equity of the company divided by the number of shares to get to the book value now for a finance course you'll always be given this number the book value per share but in accounting we actually compute this number so the reason I'm doing this because the book value is basically has to do with the equity of the business the equity means the stockholders equity section of the balance sheet. Now let's take a look at what some analysts how some analysts read this some analysts consider the stock of a firm with a low market to book ratio as a safer investment notice safer as in quote that's not really true especially for publicly trading company seeing that the book value as a as a floor supporting the market price the assumption that they're making here is this they view the book value as the level below which market prices will not fall because the form can always liquidate and sell their assets for the book value but that's not really true the way the the way we should look at the book value I'm sorry at this ratio what they're saying is some analysts are saying the closer this is the one the safer is the company because we can sell everything liquidate everything and get our money back but this is not why you invest you invest for future growth okay so this idea is very questionable okay so the lower this number the less off you are what you want is you want a bigger number and this was proven true in mid 2017 shares of Honda, Mitsubishi and Barclay sold for less than their book value so the book value is not really a floor for the stock and anyway when you buy a stock that's not really what you want you don't want a floor you want the stock price to be a multiple of the book value for example the restaurant business if the book value of the restaurant is 20 the restaurant business has a multi a p price to book a five it means the if your book value is 20 your stock price should be 100 because in the restaurant business the multiple is five for example the retailer the multiple could be eight or for example technology companies the multiple could be 15 so take your book value your stock price should be 15 times your book value how do we come up with these multiple well that's a professional judgment that's based on macroeconomics macroeconomics factor industry factors company factor and many other factor but the point is don't think that the book value the closer it is the safer you are on the contrary you want this ratio to be a multiple the price a multiple of the book value a reasonable multiple as well it cannot be too high then the price the price of the stock could be the price of the stock could be overvalued the company could be overvalued through this through the price of the stock here's walmart the price to book ratio is five five dollars and twenty seven cent so the market price is five the price the price to book market is five twenty seven well we have the market price one thirty eight seventy five from this market price i can find the book value per shares if i take one thirty eight point seven five divided by five point two seven i know the book value per share for walmart is twenty six dollars and thirty two cent so simply put walmart is trading at five point two seven times the book value because if we take the book value per share times five point two seven will give us the current price of walmart now if we look at apple apple price the book is twenty five point seven six what does that mean let's see what does that mean it means if the stock price of apple is one hundred eight dollars and eighty six cents it closed on october 30th we'll divide this by twenty five point seven six we find we we notice that we notice it's the book value we notice that the book value is per share is four dollars and twenty two cent so notice apple is trading twenty five times the book value is this justified well it all depends on what you think of apple if you think apple is justified by their future earnings then yeah you think that's a good price or you may say well based on the price to book this is a very high price compared to the book but remember the difference between apple and walmart walmart has a lot of physical asset apple does not apple is a technology company so you cannot compare the two for example you may look at microsoft with the book value of twelve point four one which is which is not as high as apple but it's higher than walmart and notice that microsoft their price to book is twelve dollars and twelve point four one times in other words microsoft is trading take their book value multiplied by twelve point four one will give you the current price of 202.47 obviously this will change because as your stock price as your stock price changes this ratio will change as well let's look at the pe ratio price to earnings ratio very similar because what you're doing here it's it's also a multiple the price of the stock okay so the price of the stock dividing by the earnings per share eps so notice the similarities between the two ratio this is the price per share divided by the book value and this ratio is the price per share divided by its future earnings or earnings per share so notice the numerator is the same the numerator is price to earnings this ratio of a stock price to its earning per share also refer as the pe multiple it's another multiple but here what we're looking at we're looking at the multiple as of the future earnings rather than the multiple as of the book value well it depends on how you look at the company if you are if you want the value the company from a book value perspective you would look at their book value and you would say i'm going to pay five times the book value or seven times the book value or if you want to buy the company based on the future earning multiple you would look at their multiple and you would say i want to pay 10 times their multiples of their earning one dollars per share and you want to pay 10 times their multiple, well, you'll pay $10 for the share. If you want to pay $15 times their multiple, if you think I should pay $15 times their multiple, then their price should be $15, so on and so forth, and we'll look at a few multiples. Low PE stocks allow you to pay less per dollar of the current earnings. So if you have a PE of eight, it means for every dollar in earnings, you are paying $8 per share. Okay, so the lower the PE, the lower you are paying for the stock. High PE stock may still be a better bargain if the earnings are expected to grow quickly enough. So high PE means you're paying many times the multiple. For example, it's making a dollar per share and the price is 40 or the price is 60. Okay, now what you're doing is for that $1 per share, you are paying $60. Now why would you pay this much? Why will you pay this much today? For example, growing companies like Tesla, Netflix, they have a high multiple, and the reason is because the future earnings, because in the future, if you buy it today, although you're paying 60 times today, but what you expect, you expect this number to go from a dollar, you'll expect this number to go from a dollar to $5. So if earnings went from a dollar to $5, let's see what happened to the multiple. Now the multiple is 12. Now it looks cheap, but now you're paying 60 because you are currently expecting $1, but down the road, if that $1 changed to $5, well, then you paid 12 times per multiple. But the thing is, what you're doing is you're buying the future. Okay, many analysts believe that low PE stocks are more attractive than high PE, not necessary. Remember, when you buy a company, you are buying the future earnings. So the PE, what it's telling you what's going to happen, but really what you're doing is the future. Okay, so a high PE ratio may be interpreted, it's always interpreted as a signal that the market, that the market views the firm as enjoying attractive growth opportunities. So high PE means growth, growth, growth opportunities. And let's take a look at the PE for Walmart, Apple and Microsoft, just going to give us a realistic example. Here, the PE ratio for Walmart is 22. Simply put, Walmart, Walmart is expected to earn $6.27 per one share. Well, the investors are willing to pay for every dollar, $22.14. So if we take $22.14 multiplied by 6.24 to 6.27, it should give us the price. So Walmart is trading at $22.14 per every dollar in earning. If we look at Apple, Apple is expected to earn $3.28 per share, $3.28 per share. The PE ratio, investors are willing to pay 33.14 times per share. Well, the investors at Apple, they're willing to pay a higher multiple, higher multiple for the future earning of Apple. Therefore, the price, if you take 33.19 multiplied by 3.28, now it becomes a rounding issue, but it should come up around $108.86. Microsoft, their future earning is $6.20 and investors are willing to pay for every dollar and earning $32.66 per share. Again, similar to Apple. So notice Microsoft, although it's trading at $202 and Apple is trading at $108, what we would say from a value perspective, they're both selling for the same price. What is that price? For every dollar in earnings, you are paying around $33 in, on average, $33 for every dollars in earning. Now, why would you pay more for Apple and Microsoft and you would only pay 22 times for Walmart? Because they have a better prospect for the future. They're going to have new product because they're on the technology front. So the expectation, so when you're buying high, the expectation is this EPS, it's going to jump into the future. So I'm buying now because I know the earnings per share will go higher. So what drives the stock price is really earnings. That's just the whole point I'm trying to make here. Here, what you're looking at is you're looking at the company and valuing the stock from in earnings rather than a book value perspective. If you look at this, you're looking at the book value multiplying the book value by certain multiple. The PE, you're looking at the earnings, future earnings, and you're multiplying the future earnings by a multiple. Now, guess what? We're going to take those two ratios and combine them together. So I'm going to take the price per share divided by the book value divided by the price per share divided by the earnings per share. Basically, take those two ratios and divide them by each other. What we're going to end up with is ROE. What we're going to end up with is earning divided by the book value, which is earnings divided by equity. Earnings divided by equity or shareholders' equity equal to return on equity. And we should be very familiar with return on equity. If not, go to my previous recordings. I have one or two recording and one specifically dissecting return on equity. So simply put return on equity where it boils down to is the price per book ratio divided by the PE ratio. So those two formulas, those two, not formulas, those two ratios divided by each other. Now, if we rearrange and manipulate this formula to compute the PE ratio, what we find out is the PE equal to the price per market or the price per book divided by ROE. So this is another way to kind of combine those two ratios together, the earnings and the book. Okay? Because remember, we looked at the company from a book value perspective, a multiple of the book value. We look at the company from the earnings perspective. Now, we combine both ratios and we come up that the PE ratio, the multiple of the company should equal to the price over book divided by ROE. Now, to kind of make a little to make a little bit more sense of this and see what drives basically, we want to see what drives the stock price at the end of the day. I made this chart kind of just to take a look at this, look at these two figures. Let's assume we're dealing with a company with a market price of 100 and the book value per share is 20. Therefore, we'd say price to book is five, 100 divided by 20 equal to five. And we're going to assume for the sake of illustration that an appropriate multiple for this company is 25. An appropriate multiple, it means a fair price for this company is 25. Now, how do we determine that this is a fair price? Well, it's based on the overall industry. Okay? Your knowledge, your judgment. So 25 times is a fair price. Now, what we would say is this, if the price to book ratio is five, if you think you should pay 25, we would say that the return, if we solve the formula, we would say that return on equity is 20%. Simply put, let me rephrase what I just said. So ROE is 20%. Then ROE should be 20%. So the stock price is 100, the book value is five, the PB is five, the return on equity is 20%. Now, let's assume, let's keep ROE is the same and let's assume the stock price went from 100 to 120. Usually the book value does not change because those are accounting figures. 120 divided by 20, we have a PB of six. If we have a PB of six and we solve for the formula, in other words, if this is six, if we keep ROE at 20%, if we don't improve our ROE, our PE ratio becomes 30. This becomes 30. What does that mean? Remember, we said 25 is a fair price. In other words, this company will deserve 25 times for every dollar they make, it deserves 25 times to be paid 25 times for every dollar. Now, what happened is, the stock price went up, the PE, the PE ratio becomes 30. Now, how can we justify the PE ratio? If we want to justify the PE ratio and buy the stocks, we would expect the PE to go up. So simply put, now we want the PE, we want the PE ratio equal to 0.25. Why? Because if we take six divided by 0.25, if we take six divided by 0.25, now the PE ratio is 24, which is closer to 25. So if you want to still buy the stock, you want the company to earn rather than 20. You want the company to earn 25% return on equity. Again, we're going back to see what drives the stock. What drives the stock is the return, whether it's represented by APS earnings per share or return on equity. You want the company to earn more in relationship to the stockholders. Same thing. If the price keeps on going up, went up to 140, now the price to market equal to 7, well, if return on equity stays at 20%, now the PE multiple is 35, the company is considered expensive. So one of things should happen, the price either go down, the price will either go down toward 100 for the multiple to go back to 25 or the company will have to earn more on return on equity. So I'm just showing you the relationship. Let's assume here we're going to keep, well, let's assume we keep the price to book at 5 and let's see what happened. Notice, if this is a fair price for the stock, which is a multiple of 25, ROE equal to 20, let's assume the company, they are now becoming more efficient, they're earning more and the return on equity is 25%. Well, if the stock does not move, if the stock stays at $100, what happens is its PE multiple becomes 20. This becomes cheap. So automatically, once this price becomes cheap, people will go in and they will start to buy the stock. They will start to drive this P up. Once they drive this P up, this will go down, this will go up to 25. So notice, what drives this whole thing is return on equity. So if return on equity, if the company earned more, the PE becomes cheaper. As the PE becomes cheaper, people will jump in and say, this is a cheap stock, let's buy the company is earning good, then it will go back to 25. Let's assume if the PE goes up to 30, if the PE goes up, I'm sorry, if the return on equity goes up to 30%, now they're making a lot of money and they're able to keep more of it for the shareholder, the PE ratio goes down to 16.67. Wow. Now we're only paying 16.67, but 25 times is a fair price. What happens is everybody will jump in and they will start to buy this stock. As a result, this P here, the price will go up and the PE ratio will go back to normal to 25. And again, you'll be able to find a fair price by filling out the formula, filling out for solving for PE to make this equal to 25, you'll find what's the appropriate price should be for the stock, giving ROE of 30. So the point of all of this is what drives the stock price? It's the earnings and the future earning of the company, either through EPS or through return on equity, which is the same thing, they're both return, which is both earnings, we're dealing with earnings. If you like this recording, please like it and share it. And as always, as always, I'm going to remind you, especially if you're a CPA candidate or an accounting student to check out my website. If you're studying for your CPA exam, this is a long-term investment in your career. CPA exam is once, once it's behind you, it's done. You don't have to worry about it anymore. So you could sit down and focus on your career. So don't short, short change yourself, invest in yourself so you can focus on your career and get ahead in life. Good luck and most importantly, stay safe.