P/E, P/B and ROE: Reading a Stock's Valuation Without a Finance Degree

Start with the only question that matters

Valuation is not about finding a cheap number. It is about answering one question: what am I paying, and what am I getting for it?

Three ratios answer most of that on a first pass. None of them works alone. All of them lie in specific, knowable ways.

P/E — the price of a rupee of profit

Price to Earnings = Share Price divided by Earnings Per Share.

A P/E of 25 means you are paying Rs 25 for every Rs 1 of annual profit the company currently earns. Flip it and you get an earnings yield of 4% — a useful sanity check against what a bond would pay you.

What P/E is really telling you

P/E is a measure of expectation, not of value. A high P/E means the market expects earnings to grow. A low P/E means it does not.

That reframing kills the single most common beginner mistake: buying a low P/E because it looks cheap. A stock at 6 times earnings is not on sale. It is being told, by a market of people who have looked at it, that those earnings are about to fall, are of poor quality, or belong to a business in decline.

Sometimes the market is wrong, and that is where value investing lives. But your starting assumption should be that the low number is a verdict, not a discount.

Where P/E breaks

Cyclicals invert it. A commodity producer at the top of its cycle shows record earnings and therefore a *low* P/E — precisely when it is most dangerous. At the bottom of the cycle, earnings collapse and the P/E looks absurdly high — often the best moment to buy. For cyclicals, a low P/E is a sell signal more often than a buy signal.

Loss-making companies have no P/E at all. The ratio is meaningless with negative earnings.

One-off items distort it. An asset sale inflates a year of profit and deflates the P/E, and the business has not changed at all.

Compare only within an industry. An IT services P/E and a bank P/E are different currencies. A 30 P/E is expensive for a PSU bank and unremarkable for a consumer brand.

P/B — the price of a rupee of net assets

Price to Book = Market Capitalisation divided by Shareholder Equity (net worth).

A P/B of 1 means you are paying exactly what the accountants say the company's net assets are worth.

Where P/B earns its keep

Banks and financial companies. For a lender, the balance sheet *is* the business. Book value is a meaningful, comparable number, and P/B is the primary lens.

Where P/B is nearly useless

Asset-light businesses. A software company, a consultancy, a consumer brand — their real assets are code, people and brand, and none of those sit on a balance sheet. A high P/B here tells you almost nothing.

Old asset bases. Land bought in 1985 sits at 1985 cost. The book value understates reality, sometimes wildly.

A P/B below 1 is not automatically a bargain. It often means the market believes the stated book value is fiction — that the assets are impaired, or the loans will not be repaid.

ROE — the ratio that separates good businesses from cheap ones

Return on Equity = Net Profit divided by Shareholder Equity.

This is the quality ratio. It answers: for every rupee shareholders have in this business, how much profit does it generate each year?

An ROE of 20% means the business turns Rs 100 of shareholder capital into Rs 20 of profit annually. That is a genuinely good business. Sustained over a decade, it is a compounding machine.

The trap inside ROE

Debt inflates it. Because equity sits in the denominator, a company can raise its ROE simply by borrowing more and holding less equity. A 25% ROE built on a mountain of debt is not quality — it is leverage wearing quality's clothes.

Always read ROE next to the debt-to-equity ratio. High ROE with low debt is the combination worth hunting. High ROE with high debt is a risk profile, not an achievement.

Putting the three together

Alone, each ratio misleads. Together, they triangulate:

- High ROE, low debt, reasonable P/E — a good business at a fair price. This is the rare, boring, wonderful quadrant. - Low P/E, low ROE — cheap for a reason. The market is usually right. - High P/E, high ROE — a quality business that everyone has already found. The business is fine; the price is the risk. - Low P/B, low ROE, in a bank — often distress rather than opportunity.

This is essentially what the quality and value factors formalise — see factor investing for how these get turned into systematic strategies.

What ratios cannot tell you

They are a screen, not a thesis. They will not tell you whether the promoter is honest, whether the moat is eroding, whether the auditor resigned, or whether the growth is real.

For that you have to open the accounts. Start with our guide to reading a balance sheet.

Disclaimer: This article is for education only and is not a recommendation to buy or sell any security. Investments in securities are subject to market risk.