Investors use stock valuation ratios as a quick way to check if the price of a company makes sense. Some use the ratios as a way to screen for stocks that might meet their investment criteria. Others might use ratios to set price targets for when they want to buy or sell a stock. Let’s take a look at some of the most popular stock valuation ratios.
Price / Earnings (P/E)
This is one of the most common ratios for stocks and is available from most financial publications. It divides the price per share of the stock with the earnings per share for the stock. The P/E ratio acts as a quick way for investors know how much money they earn from their partial ownership of a business. Historically, the stock market in the US had a P/E ratio around 15.
PE ratio / Earnings growth (PEG)
This ratio is popular among growth investors. It divides the P/E ratio of a stock by its earnings growth. Some investors use this ratio instead of a P/E ratio because a stock with a higher growth rate usually deserves a higher valuation multiple. With this measurement, a company with a high P/E ratio can still look like an attractive investment if it is growing at a high rate. The higher the PEG ratio, the more expensive the stock.
Price / Sales (P/S)
This ratio is used for its simplicity. It divides the price of the stock by its revenue per share. One of the advantages of this ratio is that investors can use it for companies that don’t have earnings yet. Also, since revenue is a top line number, there are fewer areas for accounting assumptions to distort the value of the business when compared to earnings.
Price / Book Value (P/B)
This ratio is often used by deep value investors looking at businesses with assets that are worth more than the stock. It divides the price of the stock by the book value per share. Many investors make adjustments to the book value because financial statements use accounting rules that may not be an accurate assessment of an asset’s current value.
Price / Free Cash Flow (P/FCF)
Investors use this ratio to measure how much cash a company generates from their business operations after spending on capital expenditures. It divides the price of a share by the free cash flow per share. Some investors use variants of this formula such as price / operating cash flow.
Dividend / Price (Dividend Yield)
This ratio is used by investors who are looking for income along with their stock holdings. It divides the dividend per share by the stock price. One of the benefits of dividends is the ability to reinvest the money and dollar cost average into shares that might be trading at a better price over a period of time.
Enterprise Value / Earnings before interest, taxes, depreciation, and amortization (EV/EBITDA)
The enterprise value is the market cap of the company plus the debts of the company minus the cash of the company. The EV represents the cost it would take for someone to buy an entire company and assume all its debts, but keep its cash. The EV/EBITDA ratio is used by investors to evaluate a company’s earnings that is available to satisfy bond holders and stock owners. There are many variations of this formula such as EV / EBIT.
Valuation ratios are an incomplete picture
One thing to keep in mind with all these ratios is that numbers from a financial statement are based on conventional accounting standards and sometimes require adjustments to create a more realistic picture of a company. Valuation ratios can be a useful sanity check to protect an investor from paying too much for a business, but are not enough by themselves to make investment decisions. An investor needs to understand how a business creates value and what drives the numbers in the financial statements.