P/E Ratio and Other Valuation Ratios: How to Tell if a Stock Is Cheap or Expensive

The price-to-earnings (P/E) ratio is a company's share price divided by its earnings per share: it tells you how many dollars investors are paying for each dollar of yearly profit. A high P/E usually means investors expect fast growth, while a low P/E can mean good value, high risk or temporarily high profits. No single ratio decides whether a stock is cheap, so you compare several ratios with the company's own history, its competitors and its growth.

The P/E ratio

P/E = share price / earnings per share (EPS). You can also calculate it as market cap / net income.

• Trailing P/E uses EPS from the last 12 months (actual results).
• Forward P/E uses analysts' estimates for the next 12 months or the next financial year (forecasts, which can be wrong).

Why P/E ratios differ

• Growth. Investors pay more for profits expected to grow quickly.
• Quality and risk. Stable, predictable profits earn a higher multiple than volatile ones.
• Interest rates. When safe bonds pay more, investors usually pay less for future profits, so P/E ratios across the market tend to fall.
• The cycle. For cyclical businesses (steel, chemicals, carmakers, memory chips) the P/E is often lowest at the top of the cycle, when profits are briefly high, and highest at the bottom, when profits are depressed.
• Losses. If EPS is negative, the P/E has no meaning. Use sales or cash-flow ratios instead.

The PEG ratio

PEG = P/E / expected annual EPS growth (in %). It adjusts P/E for growth.

Price-to-sales and price-to-book

• Price-to-sales (P/S) = market cap / revenue. Useful for young or temporarily unprofitable companies, but it ignores margins: $1 of sales at a 30% margin is worth far more than $1 at a 3% margin.
• Price-to-book (P/B) = share price / book value per share. Book value is the shareholders' equity on the balance sheet. It is useful for banks and insurers, whose assets are mostly financial, and much less useful for software or brand-driven companies whose main assets do not appear on the balance sheet.

Enterprise value and EV/EBITDA

Market cap is the price of the shares only. Enterprise value (EV) is the price of the whole business, debt included:

EV = market cap + total debt - cash (plus, strictly, preferred shares and minority interests).

EV/EBITDA compares that price with operating profit before depreciation and amortisation (see the income statement lesson). Because it includes debt, it is fairer than P/E when comparing companies with very different borrowing. EV/Sales does the same for revenue.

A side-by-side comparison

	Company A	Company B
Share price	$120	$45
EPS	$4.00	$3.00
P/E	30	15
Expected EPS growth	18% a year	4% a year
PEG	1.7	3.75
Market cap	$120bn	$45bn
Debt minus cash	-$10bn (net cash)	$28bn
Enterprise value	$110bn	$73bn
EBITDA	$6bn	$7bn
EV/EBITDA	18.3	10.4

B looks half the price of A on P/E. On EV/EBITDA it is still cheaper, but less dramatically, because a lot of B's value belongs to lenders. B also grows far more slowly and carries more financial risk. A is expensive, but its price is buying growth and a strong balance sheet. Neither is automatically the better investment: the question is whether each price is fair for what you get.

Other yields worth knowing

• Free cash flow yield = free cash flow / market cap. Many investors prefer it to P/E because cash is harder to dress up than accounting profit (see free cash flow and the balance sheet).
• Dividend yield = annual dividend / price (see dividends and buybacks).

How to use valuation ratios well

1. Compare with the company's own history, for example its P/E range over 5-10 years.
2. Compare with close peers, not the whole market: banks with banks, software with software.
3. Use several ratios. If P/E, EV/EBITDA and free cash flow yield all point the same way, the signal is stronger.
4. Pair valuation with quality and growth. A slightly expensive great business often beats a cheap poor one over time.
5. Do not use valuation for timing. Expensive stocks can stay expensive, and cheap ones stay cheap, for years.

Next: the cash behind the profit, in free cash flow and the balance sheet.