PER, PBR, ROE, EPS Explained for Beginner InvestorsLegendary stock investor Peter Lynch once said that there’s a reason why the majority of people make money in real estate, but not in the stock market.
People spend months on finding the right property, whereas in choosing the right stock to invest in, they only spend a few minutes.
In this post, I'll be explaining the concepts of:
1) Price Earnings Ratio (PER)
2) Price-to-book Ratio (PBR)
3) Return on Equity (ROE)
4) Earnings per Share (EPS)
by explaining the formula, what they tell us, and the best way to understand these concepts through an example.
Return on Equity (ROE)
So let’s start with the Return on Equity, or ROE.
This measures the profitability of a company in relation to stockholder’s equity.
The ROE is calculated by dividing the net income by the shareholder’s equity.
Price Earnings Ratio (PER)
Next, we have the price earnings ratio, or the PER.
This is a good tool to determine whether a company is overvalued.
The PER is calculated by dividing the current share price by earnings per share.
For instance, if a company’s share price is at $100, and their earnings per share is $10, this gives them a PER of 10.
Price-to-book Ratio (PBR)
Then, we take a look at the price to book-value ratio, or the PBR.
This measures the market’s valuation of a company relative to its book value, and is calculated by dividing the market price per share by the book value per share.
Earnings per Share (EPS)
Lastly, the EPS, or earnings per share.
This is simply the company’s profit divided by the outstanding number of shares outstanding, and works as a good indicator of how profitable a company is.
Example
- Let’s take a look at an example to help your understanding.
- You currently have $100,000, and you decide to open a restaurant.
- You are required to pay $100,000 in deposits, and $3,000 in monthly rent.
- You started this restaurant in the form of a limited liability company.
- You started the company with $100,000.
- Given that you issue shares that are worth $10, you issue 10,000 shares in total.
- A year later, you check how well your business has done.
- You find out that the restaurant did $300,000 in revenue, and after subtracting all costs, you’re left with $30,000.
- With this, you can calculate the return on equity by dividing 30,000 by 100,000, which gives you an ROE of 30%.
- Through the ROE, you look at how much return your own money was able to generate in profits.
- From the perspective of an investor, the higher the ROE, the better.
- You can also calculate the EPS, or earnings per share.
- In this case, the restaurant generates $30,000 in profits.
- So if we divide that by the number of shares, which is 10,000, we get an EPS of $3.
- Now let’s assume that you ran the business for 3 years, and you now want to sell your business to someone else, so you can move on to do other things.
- How much do you want to sell the restaurant for? After 3 years, you now have loyal customers, and it consistently generates $30,000 in profits every year.
- So, you decide to sell the restaurant for $200,000 in total, with a $100,000 premium on top of the deposit.
- If someone buys the restaurant for that price, it means that you and the other party agrees that the business is worth $200,000.
- Now if this restaurant is sold for $200,000, that means the $10 shares you hold are sold for $20.
- When we invest in stocks, this is how we make money.
- With all the information above, we can calculate the PER and PBR.
- If a restaurant that generates $30,000 in net profits gets sold for $200,000, the PER is 6.7.
- And then, we also have the PBR.
- You started the business with $100,000 of your own money, and sold it for $200,000, which gives you a PBR of 2
- For the PER and PBR, the lower the better.
- A low PER means that you are buying a company that generates a lot of net profit for a cheap price.
- Same for the PBR. The lower it is, the more undervalued it is.
Conclusion
The PER, PBR, ROE, and EPS can be great tools to help us identify whether a stock is a good buy or not. Understanding these concepts are imperative for beginner investors.
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