Why is everyone looking at P/E ratios when evaluating stocks? Is P/B actually better for Indian markets?

Price-to-Book is a much more stable way to value a business compared to the commonly cited P/E ratio. Earnings can be highly volatile but a company's net worth rarely fluctuates dramatically from year to year. The most important variable to understand in equity investing is Return on Equity or ROE.

If a business generates a 15% return on its invested capital it is creating extra value over the risk-free rate. As a rule of thumb a business generating a 15% ROE generally commands a valuation of about three times its capital. Historically over the last 45 years the median ROE of the Sensex has been around 15% and the market's average valuation has hovered around 3 to 3.2 times Price-to-Book.

During a crash like COVID stock prices plummeted but corporate earnings evaporated even faster. As a result P/E ratios still looked artificially high and masked the fact that stocks were actually cheap. Conversely the market's P/B ratio had dropped to roughly 2x during that time.

Historically whenever the Indian market's P/B falls to 2x it signals a fantastic buying opportunity.

Disclaimer: All information shared above are strictly for educational and informational purposes only. It should not be construed as financial or investment advice.