The Only Three Types of Investments You Need to Know 23professional investors focus on two valuation metrics: the price-to-
earnings ratio (P/E) and the price - to - book ratio (P/B). The P/E
ratio is simply a number that shows the relationship between a
stock price and the earnings per share of the business. For exam-
ple, for a business with a stock price of $ 20 with earnings per
share of stock of $ 2, the P/E ratio is 10. You are paying 10 times
for the earnings of the business. Another way to look at is by fl ip-
ping the ratio and looking at the earnings yield. In this case, you
are paying $ 20 for a share of stock that earns $ 2 per share; your
earnings yield is 10 percent. Obviously, the lower P/E ratios are
characteristic of value investments. It would seem intuitive that if
you could buy a share of stock for $ 20 and get $ 5 in earnings per
share (P/E of 4), you are getting a better value than a business
with a P/E of 10.
Similarly, a lower P/B often is viewed as more indicative of
a value investment. The book value, or net assets, of a business is
akin to the net worth of a household. Start with your assets (home,
savings, and investments) and deduct your liabilities (credit cards,
loans). What you are left with is your net worth or value on the
books. The same goes for a company. Take its assets (cash, inven-
tory, receivables, property) and deduct the liabilities (debt, paya-
bles); you are left with the book value of the business. It stands to
reason that if a business is selling for a lower price relative to book
value, you are getting more of a value. Paying $ 100 million for a
business with net assets of $ 75 million (P/B 1.33) seems much
more conservative than paying $ 100 million for a company with net
assets of $ 40 million (P/B 2.50).
Generally speaking, studies have shown that businesses with
lower P/E and P/B values (value stocks) have performed better
than businesses with high P/E and P/B values (growth stocks).
A well - known academic study by Professors Eugene Fama and
Kenneth French has shown that value stocks outperform growth
stocks over longer periods of time. 7 Essentially, Fama and FrenchCH002.indd 23CH002.indd 23 9/2/09 11:06:27 AM9/2/09 11:06:27 AM