Are you evaluating banking stocks? Top 3 Reasons Why P/B Ratio is More Relevant than P/E Ratio

Making investments in top banking stocks can generate stable returns and help you build a sizeable corpus. However, selecting the right banking stocks is important to achieve your financial goals as per your risk appetite.

Numerous studies have shown that the P/B (Price to Book) ratio is more important for banks than the P/E (Price to Earnings) ratio because banks are heavily dependent on their assets and liabilities. The P/B ratio compares a bank’s stock price to its book value and tells how much investors are paying for its “net assets”.

Also, since banks operate with high leverage (i.e. borrowed money), their balance sheets matter more than their earnings. The P/E ratio looks at profits, but in banks, book value better reflects financial health. This makes the P/B ratio a more accurate measure.

For more clarity, let’s check out the top three reasons why you should prefer the P/B ratio over the P/E ratio while evaluating banking stocks. Also, we will understand the meaning of both these ratios in detail.

• The P/B ratio focuses on assets and liabilities and better shows the financial health of asset-heavy banking stocks.
• The P/B ratio measures how well a bank manages its interest income versus interest costs.
• As an investor, you can use the P/B ratio to evaluate the performance of even a loss-making bank.

The P/B ratio is a comparison between the current market price of a company and its book value per share (BVPS). Here, the book value is the company’s “net worth”. It is calculated by subtracting its liabilities from its assets. Mathematically, we can represent the formula of P/B ratio as follows:

This ratio shows how much an investor is paying for the net assets of the company. For example:

• Say the P/B ratio of a banking stock is 2.
• This means investors are paying Rs. 2 for every Rs. 1 of the company’s net assets.

The P/E ratio helps you understand how much investors are willing to pay for each rupee of a company's earnings. Let’s see its formula:

For example:

• Say a company’s P/E ratio is 25.
• This means you are investing Rs. 25 to earn Rs. 1 of the company’s profit.

In this way, the P/E ratio shows how expensive or cheap a stock is based on its earnings.

The P/B ratio is especially useful when evaluating asset-heavy companies like banks. That’s because the balance sheet of such companies is more important than profits. Let’s see why the P/B ratio is a more preferred metric than the P/E ratio when evaluating banking stocks:

1. Shows how efficiently the bank is utilising its funds

The P/B ratio helps investors see which bank is managing its funds more effectively. Since most banks face similar economic conditions, like interest rates and inflation, a bank that uses its assets more efficiently will perform better.

While the P/E ratio looks at stock value compared to earnings, the P/B ratio shows the value in relation to assets. In banks, efficient use of funds is important. Therefore, the P/B ratio is a better tool for evaluating performance in the banking sector.

2. Helps to assess a bank’s spread

The P/B ratio is a good way to assess a bank’s spread. For those unaware, spread is the difference between the:

• Interest income from loans
  and
• Interest paid on deposits

It is worth mentioning that most banks have similar interest rates and costs, but their financial performance differs based on how efficiently they manage this spread. A higher P/B ratio indicates a bank is managing its spread better and keeping non-performing assets (NPAs) under control.

3. Tells whether a loss-making bank can become profitable

Be aware that you can use the P/E ratio only when a company is making profits because it relies on earnings. If a bank is losing money, the P/E ratio becomes meaningless since there are no earnings to measure. In such cases, the P/B ratio is more helpful because it focuses on the bank’s assets and liabilities. It offers a clearer picture of its financial position, even when it is not profitable.

Moreover, many loss-making banks can still become profitable by improving their financial management, especially by focusing on their spread. So, the P/B ratio remains a useful tool during loss-making phases to:

• Assess the performance of such banks
  and
• Their potential for recovery

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