Valuation ratios — P/E, P/B and EV/EBITDA

What this lesson explains and who it is for

This lesson shows how to calculate and read the three most commonly used valuation ratios: P/E, P/B and EV/EBITDA. It is written for someone who understands the income statement at a basic level and wants to stop treating a single number from a financial website as an argument for a trade. You will find formulas here, a decision about the denominator, a protocol for comparing a ratio with the company’s own history, a table to fill in, and four rules that reveal when a ratio looks good but says nothing. A ratio describes the relationship between the share price and quantities you can verify in reports — it is not a forecast of the price.

What valuation ratios actually measure

Every valuation ratio is a fraction. The numerator describes how much you pay, and the denominator what you pay it for. P/E sets the price against profit, P/B sets the price against net assets, and EV/EBITDA sets the value of the whole firm against its operating profit plus depreciation. A change in a ratio can come from either the numerator or the denominator, and that distinction matters more than the level itself. The price falls — the ratio falls, even though nothing at the company has changed. Profit falls — the ratio rises, even though the share price has not moved. Only the second case means the market is paying more for the same unit of earnings.

The formulas: P/E, P/B and EV/EBITDA step by step

EPS          = net_income / number_of_shares           # earnings per share
P/E          = price_per_share / EPS
BVPS         = equity / number_of_shares               # book value per share
P/B          = price_per_share / BVPS
EV           = market_capitalisation + interest_bearing_debt − cash
EBITDA       = operating_profit + depreciation_and_amortisation
EV/EBITDA    = EV / EBITDA

Three notes on these formulas, without which the numbers stop being comparable:

• EV has several definitions. The one above is the simplified version. Some sources add minority interests and lease liabilities and subtract other items. Record which version you use, and do not mix them in one table.
• EBITDA is not cash flow. It ignores capital expenditure, taxes and debt servicing. Two companies with an identical EV/EBITDA can have very different abilities to generate free cash.
• P/E and P/B do not exist with a negative denominator. When a company reports a loss or has negative equity, you record the ratio as “n/a”, not as a negative number, because such a number has no interpretation.

The figures for the denominator come from periodic reports. You take the price from one specific day and record that date next to the result. You will find reports and statements in the issuer’s materials — the context for reading them is described in the lesson on company analysis.

Trailing or forward, book value or market value

The difference between book value and market value is the essence of P/B. Book value is the acquisition cost of assets minus liabilities, recorded in the balance sheet; market value is what someone would actually pay for those assets. In a services firm, where value is created by people and the brand, there are almost no assets on the balance sheet, so P/B is sometimes high not because the market is overpaying but because the denominator is naturally small. That is why this ratio is used where the balance sheet genuinely describes value: at banks, at insurers and at companies whose assets are property or portfolios of holdings.

Why comparing across sectors makes no sense

A sector median works only when the companies in that sector have a similar balance sheet, similar depreciation and a similar cycle. Across sectors those conditions do not hold.

• Balance sheet. At a bank, equity is subject to regulatory requirements and the assets are mainly financial. At a services firm there is almost no fixed asset base. The same P/B means completely different things in the two cases.
• Depreciation and capital expenditure. A manufacturer has to keep investing in assets, while an IT company often does not. With the same operating profit, their EBITDA describes two different realities.
• Cycle and margin. A commodity company moves to the rhythm of the commodity price, while a consumer staples company moves to the rhythm of consumer demand. Their profits peak at different moments, so ratios calculated on the same day are not comparable.
• Accounting. Differences in how leases, revenue and write-downs are recognised mean that two operationally identical firms can show different denominators.

The rule is simple: compare a ratio only with entities of a similar model, using the same definition of the ratio and for the same period. If your sector contains three companies with different models, the sector median is not a reference point — it is an average of nothing. The fact that a competitor from another country has a lower ratio is not an exception either — it may come from its local accounting or liquidity, not from valuation.

Protocol: six steps to turn a ratio into a conclusion

A ratio on its own does not answer the question of whether to buy. Only a comparison with the company’s own history, keeping one definition, answers it. The supporting quantities calculated in this protocol:

Window_median = median of the ratio over the last N periods (same definition, e.g. N = 5 years)
Percentile    = percentage of sessions in the window in which the ratio was LOWER than today
Deviation     = (ratio_today − Window_median) / Window_median

The thresholds given below are illustrative figures — match them to the sector and to your own horizon.

1. Record the source and the date of every number. The quote from a specific day, the profit from a specific report, the definition of EV. Without this step the later points compare two different units.
2. Calculate the ratio in two versions of the denominator. Trailing and forward P/E, and for EV/EBITDA record whether you include leases. If the versions lead to different conclusions, you have just found the most important information in the whole analysis.
3. Calculate Window_median on your own data. Collect the ratio from the last five years, always calculating it by the same method, and determine the median. The median is better than the average, because a single year with a write-down does not shift it as much.
4. Determine the Percentile and the Deviation. A value below the 20th percentile means that today you are paying less than in four fifths of the observed period — still not a conclusion, only a starting point.
5. Split the change into numerator and denominator. Check whether the ratio fell because the price fell or because profit rose. The first case is often the very risk the market sees; the second is a real improvement in results.
6. Compare with the sector median on an identical definition and write the conclusion in one sentence. If after these steps you cannot point to what you are comparing the ratio with, you do not have a conclusion — you have a number.

A worked example — all figures illustrative

A sample company, referring to no real issuer. Price $40.00, net income $100 million, 50 million shares, equity $400 million, operating profit $140 million, depreciation and amortisation $60 million, interest-bearing debt $300 million, cash $100 million (all values are illustrative figures).

EPS        = 100 / 50 = 2.00 USD
P/E        = 40.00 / 2.00 = 20.0
BVPS       = 400 / 50 = 8.00 USD
P/B        = 40.00 / 8.00 = 5.0
EBITDA     = 140 + 60 = 200 million USD
EV         = (40.00 × 50) + 300 − 100 = 2200 million USD
EV/EBITDA  = 2200 / 200 = 11.0

If the five-year median P/E is 24.0 (an illustrative figure), then the Deviation = (20.0 − 24.0) / 24.0 = −16.7%. The company is cheaper than usual by one sixth — and that is the entire information this calculation provides. It does not say whether last year’s profit will repeat, nor how the market values its debt. Only setting that deviation against debt and against the sector’s prospects turns a measurement into a decision. Remember also that you record the outcome of a trade in R-multiples, not in percentages of deviation from the median.

Worksheet: ratios for three companies

Copy the table into a spreadsheet and fill it in with your own data. The columns are deliberately empty — value comes from what you calculate yourself, not from what you read here. Fill in the conclusion column only after going through the six steps of the protocol.

After a dozen rows you will see whether your deviations actually preceded gains, or merely sounded convincing. Without a recorded date and definition this cannot be checked, because after a month you will not reconstruct which version of the ratio you had in mind.

When a valuation ratio says “let it go”

Four conditions, each in the form of a rule. Meeting any one of them means postponing the decision until the denominator becomes credible — not “smaller commitment” and not “a trial entry”.

1. The denominator is one-off. Net income contains a gain on the sale of assets, the reversal of a write-down or a one-off tax relief. Then P/E is understated, because it divides by an event that will not repeat. The condition to check: compare net income with profit from continuing operations and with operating cash flow; if the difference is large, recalculate the ratio on cleaned-up profit.
2. The denominator is falling faster than the price. If the ratio is the lowest in its history while profit and margin are declining year on year, the market is discounting a future decline, not rewarding an opportunity. A low P/E with a deteriorating margin is not a buy signal but a warning.
3. A low EV/EBITDA alongside rising debt. When debt is growing and free cash flow is negative, EBITDA is working mainly to service interest rather than for the shareholder. The condition: check the debt-to-EBITDA ratio and the maturity of the nearest liabilities.
4. No point of reference. The company operates in a sector with no similar entities, or has too short a history to determine a median. If you have nothing to compare the ratio with and nothing to set it against, you do not have an analysis — you have a number from a screen.

The order of action is the reverse of intuition: first you look for a reason to reject, and only then do you build a thesis. You write the reasons for rejection down too, because without them you cannot tell discipline from fear.

Common mistakes in reading valuation ratios

• Comparing a bank’s P/E with a software company’s P/E. Different balance sheets and different cycles. A conclusion from such a comparison does not exist.
• Mixing definitions in one table. One company with forward P/E, another with trailing, a third with EBITDA calculated differently. The table looks serious and describes nothing.
• A ratio without a date and a source. Data changes after every report. A number without a date can mean something completely different today than on the day it was published.
• Treating a low P/B as protection. A low price-to-book ratio does not protect you from a write-down that reduces that value.
• Ignoring debt. P/E does not distinguish a company with no debt from a heavily indebted one. EV/EBITDA is there for that — it shows the difference most simply.
• Deciding on the basis of one ratio. Valuation is a filter, not an entry moment. Timing and direction are described by technical analysis, and position size by the 1–2 per cent risk rule.

Measurable exercise

Take three companies from the same sector. For each, record trailing P/E, forward P/E, P/B and EV/EBITDA, every number with a date and a source. Then carry out the six steps of the protocol and fill in the table. Finally, answer two questions in writing: which company looks cheapest against its own history, and what exactly accounts for that deviation — the price, the denominator, or both. Repeat the same exercise after the next quarterly report is published and compare the two sets. The difference between them will show whether you are measuring a change at the company or only a change in mood. Collect the results together with the record from earnings season.

Common questions

Which valuation ratio is the best?

None of them on its own. P/E is often good to start with, because it links price with profit, while EV/EBITDA compares firms with different debt levels more fairly. Context decides: the same definition, the same period, and a comparison with the company's own history and with similar entities.

Does a low P/E always mean an opportunity?

No. It can mean a deteriorating margin, a one-off gain in the denominator or a cycle peak. Always ask where the number in the denominator came from before you decide the company is cheap. A falling P/E alongside declining profit is usually information about risk, not about opportunity.

Where can I find the data for these ratios?

In the issuer's periodic reports and in the financial data published by the Warsaw exchange — there the denominator has a source and a date. Take the quote from one specific day and write it next to the ratio. A website that gives a P/E without information about the definition and the date is not a source, only a shortcut.

Why measure ratios at all, instead of judging valuation by eye?

Because an assessment by eye changes with the mood, while a calculated number does not. A ratio reduces price and financial result to one common unit, so you can compare companies, sectors and periods with each other. Only from recorded numbers can you check whether your deviations from the median actually preceded gains, or merely sounded convincing. Measurement is also a decision filter: it shows which companies are worth analysing further at all. It is a tool for comparison, not a forecast — check the ratio's definition and the source data in the issuer's report and with your broker.