Question on PB/PE ratio

CFA Level II Equities
#1

For the purpose of performing a relative valuation a cyclical industry, the most appropriate price multiple is?

  1. price to earnings using trailing --> I understand this must not be the answer
  2. Price to Book value
  3. price to earning using normalized earnings --> this is the answer

I understand that normalized earnings can solve the cyclical problem but why it is better than PB? because in my point of view, Book Value is also unaffected by cyclical problem.

Beside, I saw that Price to Sales is also good to cyclical industry, why? Sales is also affected correlated with net income!

#2

No Ratio is good or bad. The correct interpretation is what matters. Invariably you would use them as comparable… either with its own lagged version , normal mean version, industry average, other competitors, etc. Book Value is a great tool provided the accounting practices don’t have red flag. Clean Surplus relationship is not routinely violated. You mentioned P/S… again by the logic of sales coming down, the market may appropriately discount them/ penalize them with lower P for lower Sales… pound for pound. The gravest mistake to commit is to take any ratio on its face value and relying on snapshot value rather than a moving average. And of course it is just a judgment a the end of the day.

#3

Book value could be deceptive if companies in your sample have varying degrees of debt. One that seems overvalued might just have unusually high debt for some reason. Others might seem undervalued if the situation is reversed.

As for price to sales, my guess is that if everyone’s sales are moving together, it’s an external factor they all have in common so a logical basis for comparison.

#4

Hello.
The use of P/E and P/B mostly depends on the type of companies that are being compared. P/B will be the best option when the company we are valuing mainly consists of liquid assets or a high probability that the company is not expected to continue as a going concern.

Plant Property Equipment in the balance sheet is reported at historical cost value net of accumulated depreciation. There will be a significant difference between market and historical cost value. So the book value of equity is not the accurate representation of shareholders’ investment.

Often the is the case for capital-intensive manufacturing companies. In this case, P/E is a better option than P/B.

For cyclical companies, we can take average ROE and multiply that Value with the current adjusted Book Value Per share. We’ll get a normalized EPS and use the current price to calculate the P/E.