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P/E and P/B: The Two Sides of the Same Coin

November 14, 2012 | About:
The value investing community is a big population with different spots and stripes. Previously, I have written an article describing the similarities and differences between the Graham and Buffett value investing approaches.

The choice of valuation method or multiple is another sensitive issue that splits the value investing community into different camps. I am going to argue here that there are more similarities than differences between asset-based valuation methods and earnings-based valuation methods.

First, the price-to-book ratio can be renamed as the price-to-long term accumulated earnings. Book value of equity consists of retained earnings, share capital and accounting reserves. For companies with consistent profitability, the growth in book value is a proxy for the long-term growth rate in earnings.

Second, with certain stocks such as industrials, the bulk of the income producing assets such as property, plant and equipment and inventories are properly accounted for on the book. There is a circular reasoning at work here. Assets have value because they are income producing. Earnings have value as as long as the assets retain their income producing ability.

Lastly, both measures of book value and earnings are confined within the four walls of accounting. They are as perfect as they are imperfect. P/E investors can complain about the accuracy of asset valuation, but earnings is also full of distortions. They have their edge too. P/B allows loss-making companies to be compared with profitable ones on the same valuation metric. P/E is useful for valuing service-type companies like investment banks and consulting firms where their most valuable assets — their employees are expensed on the income statement.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

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