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A Low P/E or P/B Does Not Necessarily Mean Cheap

A column on what to check before concluding that a low multiple means cheap

Seeing a share with a low P/E or P/B makes it easy to feel this company must be cheap. But the market does not attach a low price for no reason. In most cases there is something behind a low multiple — concern about growth, unstable profit, worries about the balance sheet. What matters is not just the low number but thinking first about why is it low?.

What you'll learn
  • A low P/E or P/B does not automatically mean cheap.
  • There is usually a reason the market values that company low.
  • What to look at is not the low multiple itself but profit, growth, the balance sheet, and capital efficiency.
  • It is more practical to use a multiple as an entry point for asking why it is valued this way than as the answer.

1. Treat a low multiple as "a number with a reason", not "a bargain"

P/E measures the share price as a multiple of profit; P/B as a multiple of net assets. A low reading on either looks cheap at first glance. But that low reading may mean the market has overlooked something or the market is wary.

If current profit is only temporarily large, for instance, P/E looks low. And a company with plenty of assets that cannot turn them into profit tends to have a low P/B. So jumping in on a low multiple alone leaves you pulled along by the appearance of the number.

A low P/E does not necessarily mean cheap
If current profit is only temporarily large, P/E looks low. When profit returns to normal, P/E jumps and the apparent cheapness disappears.
When profit is temporarily large, P/E looks lowIf profit falls back, P/E rises and the “cheap” look disappearsThis period (strong profit)Share priceProfitP/E = price / profit8דLooks cheap”From next periodNext period (profit falls)Share priceProfitP/E = price / profit20דIt was not cheap”

2. A low P/E and a low P/B are low for different reasons

When P/E is low, the first thing to ask is will the current profit continue?. For a company whose profit swings with the economy, or one merely having a strong spell, using current profit as the base makes P/E look low. The market may be pricing the shares lower because it expects future profit to fall.

When P/B is low, what matters is how efficiently the assets it holds are being used. A company with assets but low margins, weak capital efficiency, or growth investment that is not working tends to be valued low against net assets. So a low P/B can reflect not putting the assets to work rather than having assets the market fails to recognise.

So neither P/E nor P/B is simply better for being low. You need to separate whether the reason is a temporary misreading or weakness in the business or the balance sheet.

A low P/E and a low P/B have separate causes
P/E turns mainly on how durable the profit is; P/B on weak capital efficiency. Both are “low”, but you look at different things.
P/E and P/B are low for different reasonsWhen P/E is lowAsk “will the profit continue?”CyclicalProfit inflated by a strong economyA one-off gainAn asset sale, for instanceConcern about slowing growthThe market pricing aheadWhen P/B is lowAsk “are the assets being put to work?”Low capital efficiencyROE at a low levelGrowth investment misfiringCapex not turning into profitStructural problems across the sectorFalling demand, for instanceFor both, “low = cheap” does not hold — check the reason it is low

3. Judge cheapness by the background, not the multiple

Something may genuinely be cheap when the market is strongly wary yet the foundations of the business and the balance sheet have not really broken down. Conversely, if profit is unstable, debt is heavy, and the growth outlook is weak, a low multiple may be an entirely natural valuation.

Working through it in this order makes it easier to sort out.

  1. How does this company make money?
  2. Is that profit likely to continue steadily?
  3. Is anything stretched on the balance sheet?
  4. Compared with similar companies, why is only this one low?

Follow that order and you can put the background into words before concluding a low multiple means cheap. Multiples are useful measures, but rather than reaching a conclusion there, it is more practical to use them as an entry point for asking why is the market attaching this price?.

A check flow for when you see a multiple
Understand what the business is first, then use a peer comparison at the end to ask “why is only this company low?”.
When you see a low multiple, check in this orderFour steps for laying out the background before concluding it is “cheap”1Source of earningsHow does it make money?2Stability of profitIs it likely to continue?3Financial healthIs anything stretched?4Peer comparisonWhy is only this company low?What the business isRelative valuation
A multiple is an entry point for a question, not an answer

When you see a low P/E or P/B, thinking first about why is it low? matters more. Without being able to explain the reason, you cannot really judge whether the company is genuinely cheap.

Returning to the main text

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On this page

1. Treat a low multiple as "a number with a reason", not "a bargain"2. A low P/E and a low P/B are low for different reasons3. Judge cheapness by the background, not the multipleReturning to the main text