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Key Valuation Ratios: Is the Stock Cheap or Expensive?

🌟 The Million-Dollar Question: What's It Worth?​

You've analyzed a company's performance with profitability ratios and assessed its stability with liquidity and solvency ratios. You've found a high-quality, financially sound business. Now you face the most critical question of all: Is the stock price fair? A great company can be a terrible investment if you overpay. Valuation ratios are the tools that help us answer this question. They connect a company's stock price to its underlying financial reality, helping us gauge whether a stock is cheap, expensive, or fairly priced.

The P/E Ratio: The King of Valuation Metrics​

The Price-to-Earnings (P/E) Ratio is the most famous and widely used valuation metric. It's simple, intuitive, and powerful.

  • Formula: P/E Ratio = (Market Price per Share / Earnings per Share)
  • What it tells you: The P/E ratio tells you how many dollars investors are willing to pay today for every one dollar of the company's current earnings. A P/E of 20 means investors are paying $20 for $1 of earnings.
  • Interpretation: A high P/E can mean a stock is expensive, or it can mean that investors have high expectations for future growth. A low P/E can mean a stock is cheap, or it can mean the company has underlying problems. Context is everything.

The P/S Ratio: A Tool for Unprofitable Growth​

What if a company isn't yet profitable? A fast-growing tech company might be investing heavily and have negative earnings, making the P/E ratio useless. This is where the Price-to-Sales (P/S) Ratio comes in.

  • Formula: P/S Ratio = (Market Price per Share / Revenue per Share)
  • What it tells you: The P/S ratio compares the company's stock price to its revenue. It shows how much investors are willing to pay for every dollar of sales.
  • Interpretation: This ratio is excellent for valuing growth companies that haven't yet reached profitability or for comparing companies in cyclical industries where earnings can be volatile. A lower P/S ratio is generally considered better.

The P/B Ratio: Valuing the Assets​

The Price-to-Book (P/B) Ratio takes a different approach. Instead of looking at earnings or sales, it compares the stock price to the company's "book value"—the net asset value of the company from its balance sheet.

  • Formula: P/B Ratio = (Market Price per Share / Book Value per Share)
  • What it tells you: The P/B ratio tells you how much you're paying for the company's net assets. A P/B of 1 means you're paying exactly the stated book value.
  • Interpretation: This ratio is most useful for valuing asset-heavy businesses like banks, insurance companies, or industrial firms. A low P/B ratio can be a sign of an undervalued company, a favorite metric of classic value investors like Benjamin Graham.

The PEG Ratio: Adding Growth to the Equation​

A common criticism of the P/E ratio is that it doesn't account for growth. A company with a high P/E might be justified if its earnings are growing very quickly. The Price/Earnings-to-Growth (PEG) Ratio solves this problem.

  • Formula: PEG Ratio = (P/E Ratio / Annual EPS Growth Rate)
  • What it tells you: The PEG ratio standardizes the P/E ratio by factoring in earnings growth.
  • Interpretation: A PEG ratio of 1 is often considered to represent a fair value, where the P/E ratio is in line with the company's growth. A PEG below 1 may suggest a stock is undervalued relative to its growth prospects.

No Single Ratio Tells the Whole Story​

It is critical to remember that no single valuation ratio is perfect. Each has its strengths and weaknesses, and each is more or less suitable for different types of companies. A P/E ratio is great for a stable, profitable company but useless for a pre-profit startup. A P/B ratio is great for a bank but tells you little about a software company whose main assets are intangible. The key is to use a combination of these ratios to build a well-rounded view of a stock's valuation.

💡 Conclusion: Price is What You Pay, Value is What You Get​

Valuation ratios are the bridge between a company's underlying financial health and its stock price in the market. They are the tools that help us follow Warren Buffett's famous advice: "Price is what you pay; value is what you get." By using P/E, P/S, P/B, and PEG ratios, you can move beyond simply identifying good companies and start identifying good investments by making an educated guess about whether the price is fair.

Here’s what to remember:

  • Valuation is Relative: These ratios help you determine if a stock is cheap or expensive relative to its own earnings, sales, assets, and growth.
  • Use the Right Tool for the Job: Use P/E for profitable companies, P/S for growth companies, and P/B for asset-heavy companies.
  • Growth Matters: The PEG ratio is a powerful tool for putting a company's P/E ratio into the context of its future growth prospects.

Challenge Yourself: Calculate the P/E ratio and the P/S ratio for the company you've been researching. Then, find the average P/E and P/S ratios for its industry (you can find this with a quick web search like "average P/E for the software industry"). How does your company's valuation compare to its peers?

➡️ What's Next?​

We've now covered how to analyze a single company from the inside out. But companies don't exist in a vacuum. Their performance is deeply affected by the health of the overall economy. In the next article, "Economic Indicators: GDP, unemployment, and inflation," we'll zoom out and learn how to read the vital signs of the economy that impact all our investments.

📚 Glossary & Further Reading​

Glossary:

  • Valuation Ratios: Financial metrics that compare a company's stock price to an aspect of its underlying financial health to help determine if the stock is fairly valued.
  • Price-to-Earnings (P/E) Ratio: A ratio that compares a company's share price to its earnings per share.
  • Price-to-Sales (P/S) Ratio: A ratio that compares a company's stock price to its revenues.
  • Price-to-Book (P/B) Ratio: A ratio used to compare a company's market capitalization to its book value.
  • PEG Ratio: A ratio that enhances the P/E ratio by adding expected earnings growth into the calculation.

Further Reading: