Price, value and expectations
A share price reflects not current results but the market’s expectations of the cash the company will earn in future. So valuation is less about “what is this company worth” and more like reading backward “what future is built into today’s price”. The same results push a stock up if they beat expectations and down if they fall short.
P/E, P/B and ROE are one equation
- P/E = share price ÷ earnings per share (EPS) = market cap ÷ net income
- P/B = share price ÷ book value per share (BPS) = market cap ÷ equity
- ROE = net income ÷ equity
The three are not separate numbers.
P/B = P/E × ROE (market cap/equity = market cap/net income × net income/equity)
ROE can be broken down further (DuPont analysis): ROE = net margin × asset turnover × leverage (assets/equity). If a high ROE comes from debt (leverage), it will swing sharply when the economy turns bad.
Same P/E but different ROE means different P/B
P/E 10 × ROE 5%
P/B 0.5Earns little on its equity
P/E 10 × ROE 20%
P/B 2.0Earns a lot on its equity
EV/EBITDA and PEG
EV/EBITDA divides the price of the whole company (EV, chapter 1) by operating profit before depreciation (EBITDA, chapter 6). It is fairer than P/E when comparing companies with more or less debt, or with different depreciation methods. It is widely used in industries with heavy equipment and debt, such as telecoms, utilities and infrastructure.
PEG = P/E ÷ earnings growth rate (%). A P/E of 30 with earnings growing 30% a year gives a PEG of 1; with a P/E of 10 and no growth, PEG means nothing. But growth forecasts are easily wrong, so PEG is better used to gauge “how fast must it grow to justify this P/E”.
The dividend discount model and interest rates
If you assume a company pays dividends that grow at a steady rate forever, today’s fair price becomes simple (the Gordon growth model).
Price = next year’s dividend ÷ (required return − growth rate)
How the fair price changes with the required return (rates)
DCF is a calculator of assumptions
Discounted cash flow (DCF) forecasts future free cash flow (chapter 6), discounts it to present value and adds it up. In theory it is the most accurate method, but the result changes as much as you like with the assumptions you put in. In particular, the terminal value, which packs the distant future into one number, often makes up more than half of the total.
The P/E paradox of cyclical stocks
In industries where earnings swing widely with the economy, such as semiconductors, chemicals, shipbuilding and shipping, P/E sometimes has to be read in reverse.
- At the peak of a boom: earnings are at their highest, so P/E is at its lowest and the stock “looks cheap”. But the market may already be pricing in earnings that will soon shrink.
- At the bottom of a slump: earnings are near zero or negative, so P/E is very high or can’t be calculated. Yet this is often when the share price passes its bottom.
So for cyclical stocks, look at average earnings across the whole cycle, P/B and industry indicators (prices, inventories) rather than one year’s P/E.
The P/E paradox of cyclical stocks
Peak earnings
P/E 5Looks cheap, but earnings may soon shrink
Minimal earnings or losses
P/E 40+Looks expensive, but the price is often passing its bottom
Value traps and growth traps
- Value trap: a stock that is cheap on the numbers but stays cheap or gets cheaper. The industry may be shrinking, the company may not return profits to shareholders (low dividends, buybacks not cancelled), or governance problems may let minority shareholders’ value leak away.
- Growth trap: when high growth is already fully in the price. Even if growth continues, a slight slowdown versus expectations shrinks the P/E and the share price falls. A “good company” and a “good price” are different things.
Pitfalls of relative valuation: against what, and whose earnings
“It’s cheap because its P/E is below the industry average” hides two choices.
- What you compare with: even within an industry, different business mixes, growth rates and financial structures naturally mean different multiples. Comparing a company that earns most of its revenue from another business just by its industry label leads to odd conclusions.
- The timing of earnings: the number differs a lot depending on whether it uses the last 12 months’ earnings (trailing P/E) or estimated earnings for the next 12 months (forward P/E). The faster a company’s earnings change, the bigger the gap. Use the same basis when comparing.
Re-rating: why multiples change
Share price = earnings × multiple (P/E). A share price rises either because earnings grow or because the market gives the same earnings a higher multiple (re-rating). Multiples change with the following factors.
- Durability of growth: once the market believes growth is structural rather than a temporary boom, the multiple rises.
- Quality and stability of earnings: as the share of recurring revenue grows and volatility falls, the multiple rises.
- Shareholder returns and governance: with steady dividends and buyback cancellations and stronger protection for minority shareholders, the same earnings fetch a higher price. That is why governance problems are often cited for the low multiples in the Korean market.
- Interest rates: when rates fall the whole market’s multiple rises, and when they rise it falls.
Share price = earnings × multiple
Working backward: the growth priced in today
Instead of calculating value directly, you can work backward to see what assumptions today’s price needs to be justified. Rearranging the growth model above gives:
Growth g assumed by the market = required return − (next year’s cash flow ÷ present value)