The price-to-earnings (PE) ratio and the network value to transaction (NVT) ratio are useful financial indicators to analyze for smart investment decisions. The former has better applicability to the stock market, while the latter is more focused on crypto investments. Both of these ratios are particularly useful for identifying undervalued and overvalued assets.
What Is the Price-to-Earnings (P/E) Ratio?
The P/E ratio is a financial metric used to measure a company’s share price relative to its earnings per share. It is an indicator of whether the market undervalues or overvalues a particular company/stock. The formula for the P/E ratio is:
P/E ratio = Price per share / Earnings per share
The earnings per share are calculated using the following formula:
Earnings per share = Company’s profit / The number of outstanding shares
Example of a company’s P/E Ratio
The number of outstanding shares in the formula above is all the shares of the company held by its shareholders, and not by the company itself. For example, a company called XYZ has a current share price of $1,000, achieves a yearly profit of $100 million, and has 200,000 outstanding shares. XYZ’s P/E ratio is then:
$1,000 / ($100,000,000 / 200,000) = 2
What Is Considered a Good P/E ratio?
A P/E ratio of one company by itself is unlikely to give you a good insight. Normally, P/E ratios are derived for all companies in a competitive set, or, for the top companies in an industry, and the results are compared to the company’s P/E ratio. Relatively high P/E ratios usually indicate one of the two very distinct scenarios:
- Investors are putting a lot of faith in the company and its future growth. In this case, the company might be a good investment option, as the market expects it to grow.
- The company is currently overvalued and thus, may not be the best candidate to invest in.
As evident from these two scenarios, a high P/E ratio is not necessarily a good or a bad thing. But when evaluating a company with a relatively high P/E ratio for its industry, it is important to conduct the necessary fundamental market analysis to identify which of the two common scenarios above is the main reasoning for the high ratio.
Conversely, relatively low P/E ratios may indicate that:
- The market has a critical view of the company’s future potential. In this case, it is best to avoid investing in this company.
- The company is currently undervalued relative to its potential, and is, therefore, a great candidate for investment.
What Are the Advantages and Disadvantages of the P/E ratio?
Advantages of the P/E ratio
The P/E ratio is one of the most fundamental financial measures and it has a number of advantages for investment analysis:
- The P/E ratio can help identify undervalued stocks that are good candidates for future growth.
- The P/E ratio is a great gauge of a stock’s real per share profitability. The share price by itself is a rather meaningless statistic for a company analysis, while the P/E ratio immediately tells you how profitable the company is on a per share basis.
- The P/E ratio is a simple measure easily understandable even by those who do not have specialized finance skills. As such, it can be used by a wide variety of investors to quickly assess a potential investment opportunity.
Limitation of the P/E ratio
However, the P/E ratio has some limitations, among which the key ones are:
- As evident from the previous section, the P/E ratio fails to give conclusive answers based on its value. A high P/E ratio may be indicative of a stock’s attractiveness (if the ratio is high due to market optimism regarding the stock), or it could also be indicative of the stock being overvalued and thus, not worth investing in. The same applies to a low P/E ratio – it is not a conclusive indicator either for or against investing in a stock.
- There is no absolute value of the P/E ratio that can be defined as a “high ratio” or a “low ratio.” P/E ratio values are mostly meaningful only relative to industry averages. For example, the average P/E ratio for the finance industry is around 13, while the technology sector has a P/E ratio of nearly 40. The lack of an absolute guide adds to the confusion when using the ratio and makes comparison of stocks from different industries virtually impossible.
- Companies that have not been profitable over the analyzed period, e.g., the past 12 months, do not have a P/E ratio. However, some of these companies can still be good candidates for investment if they have sound future potential and are currently undervalued.
What Is the NVT Ratio?
The P/E ratio is hard to apply to the crypto industry since cryptocurrencies do not have earnings in the same sense as companies do. An alternative measure to the P/E ratio applicable to cryptocurrencies is the NVT ratio.
Crypto NVT Ratio
The NVT ratio for a cryptocurrency is derived by dividing its market cap by the 24-hour transaction volume. It has a roughly similar interpretation to the P/E ratio, i.e., a high NVT is an indicator of either market optimism towards the crypto asset or a sign of an overvalued asset.
What Are the Advantages and Disadvantages of the NVT Ratio?
Advantages of the NVT Ratio
Some of the advantages and limitations of the NVT ratio are similar to those of the P/E ratio, yet some others are unique to this measure. Among the NVT ratio’s advantages are:
- Similar to the P/E ratio, the NVT ratio can help identify undervalued crypto assets worth investing in.
- Similar to the P/E ratio, the NVT ratio is easy to calculate and equally easy to understand even for those without sophisticated financial analysis skills.
- The NVT ratio eloquently solves the problem of applying the standard P/E ratio in the cryptocurrency industry. It was first introduced in February 2017 by cryptocurrency analyst Willy Woo, and has become a widely-used measure in crypto investment analysis.
- The NVT ratio does not suffer from the cross-industry compatibility problem inherent in the P/E ratio. The NVT ratio is applied within one industry, cryptocurrencies, and therefore, NVT ratios of different cryptos can be easily compared to each other without reservations.
The key limitations of the NVT ratio
- Inability to make confident conclusions from a particular NVT value. Similar to the P/E ratio, a high or a low NVT ratio may or may not be indicative of an asset’s worthiness from the investment point of view.
- There is still an ongoing debate as to whether the NVT ratio is truly an equivalent measure to the P/E ratio. While the NVT ratio has provided a workaround to use a “P/E-like” metric in the crypto industry, some analysts question the equivalence of these two ratios. They opine that the 24-hour transaction volumes used in the NVT’s denominator are far from a similar measure to the earnings per share(the value used in the P/E ratio’s denominator).
- The NVT ratios can be very volatile since they are partly based on the 24-hour transaction volumes, a metric that can vary significantly day to day, particularly for smaller-cap cryptocurrencies.
What Are the NVT Ratios for the Top Cryptocurrencies?
The top 100 cryptocurrencies by market cap have the average NVT ratio of 43, while the top 10 cryptos have the average NVT ratio of 17. The table below shows the NVT ratio values for the current top 10 cryptocurrencies (in the descending order of the ratio).
|SHIBA INU SHIB||2.2|
BNB and BTC have the highest NVT ratios among the top crypto assets, while USDT has the lowest, at just 0.7. Three cryptos, DOGE, SHIB, and USDT, have markedly lower NVT ratios than the rest of the pack.
The P/E ratio has been a cornerstone of investment analysis for decades. The crypto industry had struggled with finding an equivalent measure to use until early 2017, when the NVT ratio was first introduced. Essentially, the NVT ratio helped bring the key elements of the P/E ratio analysis to the crypto world. The ratio can be a valuable tool to identify undervalued or overvalued crypto assets.
There is still a debate as to whether the NVT ratio is truly a suitable equivalent of the P/E ratio for cryptocurrencies. As of now, despite its limitations, the NVT ratio has established itself as the closest concept to the P/E ratio for the crypto industry.
A smart crypto investor can use the NVT ratio, while keeping in mind its volatility and other limitations. The ratio’s simplicity of calculation makes it a poor excuse not to use it as part of the overall crypto investment analysis.