Stock Valuation Explained: P/E, P/S, P/B, and Other Key Ratios

Is a stock cheap or expensive? That's the fundamental question of valuation.

A $500 stock isn't expensive if it's worth $700. A $10 stock isn't cheap if it's worth $5. Price alone tells you nothing — you need to compare price to what the company is actually worth.

This guide explains the key valuation metrics, what each one tells you, and how to use them to make better investment decisions.

What Is Valuation?

Valuation is the process of determining what a stock is worth relative to its price.

The core question: Is the current price justified by the company's fundamentals?

Two main approaches:

1. Absolute valuation: What is the company intrinsically worth? (DCF, asset-based)
2. Relative valuation: How does this compare to similar companies? (P/E, P/S, etc.)

Most investors use relative valuation because it's simpler and more practical. This guide focuses on relative valuation metrics.

P/E Ratio: The Most Common Metric

The Price-to-Earnings (P/E) ratio is the most widely used valuation metric.

What It Is

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P/E Ratio = Stock Price / Earnings Per Share (EPS)

Example:

• Stock price: $150
• EPS (trailing 12 months): $6.00
• P/E = $150 / $6.00 = 25x

Interpretation: You're paying $25 for every $1 of earnings.

Types of P/E

How to Interpret P/E

P/E Limitations

When P/E fails:

• Negative earnings: P/E is meaningless for unprofitable companies
• Cyclical companies: Earnings swing wildly, distorting P/E
• One-time items: Unusual charges or gains skew EPS
• Different accounting: Companies in same industry may account differently
• Growth differences: A 40 P/E for 50% grower ≠ 40 P/E for 5% grower

PEG Ratio: P/E Adjusted for Growth

The PEG ratio accounts for growth, addressing P/E's biggest limitation.

What It Is

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PEG Ratio = P/E Ratio / Earnings Growth Rate

Example:

• P/E ratio: 30
• Expected earnings growth: 25% per year
• PEG = 30 / 25 = 1.2

How to Interpret PEG

The PEG Rule of Thumb

Peter Lynch popularized this:

• PEG < 1: Stock may be undervalued
• PEG = 1: Fair value (P/E matches growth rate)
• PEG > 1: Stock may be overvalued

Example comparison:

Company A looks expensive on P/E (40 vs 20), but cheaper on PEG (1.0 vs 2.0).

PEG Limitations

• Which growth rate? (This year, next year, 5-year?)
• Growth estimates are often wrong
• Doesn't work for slow/no growth companies
• Ignores quality of earnings

Price to Sales (P/S): When Earnings Don't Exist

P/S ratio compares price to revenue instead of earnings.

What It Is

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P/S Ratio = Market Cap / Annual Revenue

Or:

P/S Ratio = Stock Price / Revenue Per Share

Example:

• Market cap: $100 billion
• Annual revenue: $50 billion
• P/S = $100B / $50B = 2.0x

When to Use P/S

Use P/S when:

• Company is unprofitable (P/E doesn't work)
• Earnings are volatile or temporarily depressed
• Comparing companies with different margins
• Evaluating high-growth companies reinvesting profits

P/S works because:

• Revenue is harder to manipulate than earnings
• More stable than earnings for cyclical businesses
• Useful for early-stage growth companies

How to Interpret P/S

Important: P/S varies dramatically by industry. A 10x P/S software company may be cheaper than a 2x P/S retailer.

P/S Limitations

• Ignores profitability entirely
• Doesn't account for margins
• 1x P/S with 5% margin ≠ 1x P/S with 20% margin
• Revenue growth without profit path is dangerous

Price to Book (P/B): Asset-Based Valuation

P/B compares price to the company's net asset value.

What It Is

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P/B Ratio = Stock Price / Book Value Per Share

Where:
Book Value = Total Assets - Total Liabilities

Example:

• Stock price: $50
• Book value per share: $25
• P/B = $50 / $25 = 2.0x

How to Interpret P/B

When P/B Works Best

Good for:

• Banks and financial institutions
• Asset-heavy businesses (real estate, manufacturing)
• Liquidation analysis
• Companies with tangible assets

Bad for:

• Tech companies (intangible assets)
• Service businesses (few assets)
• Companies with obsolete assets on books

P/B Limitations

• Book value is accounting value, not market value
• Intangible assets (brand, IP) often excluded
• Assets may be carried at historical cost
• Different industries have wildly different P/B norms

EV/EBITDA: The Acquisition Metric

EV/EBITDA is favored by corporate buyers and sophisticated investors.

What It Is

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EV/EBITDA = Enterprise Value / EBITDA

Where:
Enterprise Value (EV) = Market Cap + Debt - Cash
EBITDA = Earnings Before Interest, Taxes, Depreciation, Amortization

Why Use Enterprise Value?

Market cap only measures equity value. Enterprise value measures total business value:

• Includes debt (buyers assume it)
• Subtracts cash (buyers get it)
• Better for comparing companies with different leverage

Example:

Same market cap, very different enterprise values.

Why Use EBITDA?

EBITDA removes:

• Interest: Different capital structures
• Taxes: Different tax situations
• Depreciation/Amortization: Non-cash charges

This makes comparisons cleaner across companies.

How to Interpret EV/EBITDA

When to Use EV/EBITDA

Best for:

• Comparing acquisition targets
• Capital-intensive businesses
• Companies with different debt levels
• Cross-border comparisons (tax-neutral)

Not ideal for:

• Companies with high capex needs
• Banks (different business model)
• Companies with significant working capital differences

Price to Free Cash Flow (P/FCF)

Free cash flow is the cash left after running the business and investing in it.

What It Is

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P/FCF = Market Cap / Free Cash Flow

Where:
Free Cash Flow = Operating Cash Flow - Capital Expenditures

Why FCF Matters

Cash flow > Earnings because:

• Cash is real, earnings are accounting
• FCF funds dividends, buybacks, debt paydown
• Harder to manipulate than earnings
• Shows true profit after necessary reinvestment

How to Interpret P/FCF

P/FCF vs P/E

Dividend Yield

For income investors, dividend yield measures return from dividends.

What It Is

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Dividend Yield = Annual Dividend Per Share / Stock Price

Example:

• Annual dividend: $4.00 per share
• Stock price: $100
• Yield = $4.00 / $100 = 4%

How to Interpret Yield

Yield Traps

Warning: Very high yields often signal trouble.

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Example of a yield trap:
- Stock falls from $100 to $50
- Dividend is $4.00 (unchanged)
- Yield jumps from 4% to 8%
- Looks attractive, but price fell for a reason
- Company may cut dividend next

Check before buying high yield:

• Payout ratio (dividend / earnings)
• FCF coverage (dividend / free cash flow)
• Dividend history (growing, stable, or cut?)
• Business fundamentals

Comparing Valuation Metrics

When to Use Each Metric

Sector-Specific Metrics

Different sectors favor different metrics:

Relative Valuation: Context Matters

No valuation metric means anything in isolation. Always compare:

1. Compare to History

How does current valuation compare to the stock's own history?

Example:

• AAPL 5-year average P/E: 22
• AAPL current P/E: 28
• Premium to history: 27%

Question: Is 27% premium justified by faster growth, better margins, or new products?

2. Compare to Peers

How does valuation compare to competitors?

Example:

GOOGL looks cheaper than MSFT on P/E, and growth rates are similar.

3. Compare to Market

How does valuation compare to the overall market?

• S&P 500 average P/E: ~22
• Stock P/E: 35
• Premium to market: 59%

Question: Does this company deserve a 59% premium? Why?

4. Compare to Growth

Always relate valuation to growth:

Stock A looks expensive but is cheapest relative to growth.

Valuation in Practice

Step-by-Step Valuation Process

Step 1: Gather the metrics

• P/E (trailing and forward)
• P/S
• EV/EBITDA
• P/FCF
• Relevant sector-specific metrics

Step 2: Compare to history

• 5-year average for each metric
• Current vs historical percentile

Step 3: Compare to peers

• Direct competitors
• Industry averages

Step 4: Consider growth

• Calculate PEG
• Relate valuation to growth rate

Step 5: Form conclusion

• Is current valuation justified?
• What's priced in?
• Where could expectations be wrong?

Example Analysis

Stock: Microsoft (MSFT)

Observation: Trading at premium to history and peers across all metrics.

Key questions:

• Is Azure growth accelerating enough to justify premium?
• Are AI investments creating new value?
• What are the risks to the premium?

Common Valuation Mistakes

Mistake 1: Using One Metric

Single metrics give incomplete pictures.

Fix: Use multiple metrics to triangulate fair value.

Mistake 2: Ignoring Context

A 10 P/E isn't automatically cheap. A 50 P/E isn't automatically expensive.

Fix: Always compare to history, peers, and growth.

Mistake 3: Comparing Across Sectors

Comparing tech P/S to bank P/S is meaningless.

Fix: Compare within industries only.

Mistake 4: Chasing "Cheap"

Value traps look cheap for a reason.

Fix: Understand WHY something is cheap before buying.

Mistake 5: Paying Any Price for Growth

Growth doesn't justify infinite valuation.

Fix: Even great companies can be bad investments at wrong prices.

Mistake 6: Ignoring Quality

A cheap, poorly managed company may deserve to be cheap.

Fix: Combine valuation with quality assessment.

Quick Reference: Valuation Cheat Sheet

Key Ratios

When to Use What

Red Flags

• Extremely high valuations (50+ P/E) without matching growth
• Extremely low valuations (sub-10 P/E) in declining business
• Very high dividend yield (7%+) — potential cut coming
• P/S above 10 for mature company
• Valuation metrics all pointing different directions

Frequently Asked Questions

What is a good P/E ratio for a stock?

There's no universal "good" P/E. The S&P 500 average is around 20-25. Growth stocks often trade at 30-50+ P/E, while value stocks trade at 10-15. Compare a stock's P/E to its industry peers, its own historical average, and its growth rate. A lower P/E isn't always better if the company isn't growing.

What's the difference between trailing and forward P/E?

Trailing P/E uses the last 12 months of actual earnings (backward-looking). Forward P/E uses analyst estimates for the next 12 months (forward-looking). Forward P/E is more relevant for fast-growing companies where future earnings differ significantly from past earnings.

When should I use Price to Sales instead of P/E?

Use P/S ratio when a company has no earnings (unprofitable) or volatile/negative earnings. P/S is useful for high-growth companies reinvesting all profits, turnaround situations, or comparing companies with different profit margins. Revenue is harder to manipulate than earnings.

What does EV/EBITDA tell you that P/E doesn't?

EV/EBITDA accounts for debt and cash, making it better for comparing companies with different capital structures. It also ignores non-cash charges like depreciation. Use EV/EBITDA for capital-intensive businesses, companies with significant debt, or when comparing potential acquisition targets.

How do I know if a stock is overvalued or undervalued?

Compare the stock's current valuation ratios to: 1) its historical average, 2) industry peers, 3) the overall market, and 4) its growth rate. A stock trading above historical averages isn't necessarily overvalued if growth has accelerated. Context matters more than absolute numbers.

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