Stock Valuation Ratios Explained: P/E, PEG, Price-to-Book and More
Is a stock cheap or expensive? Valuation ratios are the shorthand investors use to answer that, but each one measures something different and each one can mislead. Here is how P/E, forward P/E, PEG, price-to-sales, price-to-book, EV/EBITDA and free cash flow yield work, and when to use which.
A share price on its own says nothing about value. A $20 stock can be expensive and a $900 stock can be cheap, depending on what the company earns, owns and is expected to become. Valuation ratios scale the price against something fundamental so companies can be compared. They are useful shortcuts, as long as you know what each one leaves out.
Price-to-earnings (P/E)
The most quoted ratio divides the share price by earnings per share. Equivalently, it is market capitalization divided by net income. A P/E of 20 means investors are paying $20 for every $1 of annual profit.
There are two main versions:
- Trailing P/E uses the last 12 months of reported earnings. It is factual but backward-looking.
- Forward P/E uses analysts' consensus estimates for the coming year. It reflects expectations but depends on forecasts that often change.
Read P/E with care:
- It breaks when earnings are tiny or negative. A company with near-zero profit can show a P/E in the hundreds; a loss-maker has no meaningful P/E at all.
- Cyclical companies invert the logic. Automakers, chipmakers and materials firms often look cheapest on P/E at the top of a cycle, when profits peak, and most expensive at the bottom.
- Accounting choices matter. One-off gains inflate earnings and push P/E down; check whether GAAP or adjusted EPS is being used.
The inverse of P/E, earnings yield (EPS divided by price), is handy for comparing stocks with bond yields, though the two are not equivalent: bond interest is contractual, while earnings are neither guaranteed nor fully paid out.
PEG ratio
The PEG ratio divides P/E by the expected annual earnings growth rate (in percentage points). A P/E of 30 with 30% expected growth gives a PEG of 1; the same P/E with 10% growth gives a PEG of 3.
PEG tries to account for the fact that faster-growing companies deserve higher multiples. Its weakness is the growth figure itself: it is an estimate, often over a short horizon, and small changes in that assumption swing the ratio widely.
Price-to-sales (P/S)
Price-to-sales divides market cap by annual revenue. It works for companies that are not yet profitable, such as early-stage software or biotech firms, and it is harder to distort through accounting than earnings.
The catch: revenue is not profit. A grocery chain with thin margins and a software firm with high margins should not trade on similar P/S multiples, so this ratio is mostly useful within an industry.
Price-to-book (P/B)
Price-to-book divides market cap by shareholders' equity (assets minus liabilities) on the balance sheet. A P/B below 1 means the market values the company at less than its accounting net worth.
P/B is most relevant for banks, insurers and other financial firms, whose assets are largely financial and marked close to market value. It is far less useful for asset-light companies whose value lies in brands, software, patents or people, none of which show up fully on the balance sheet. Large buybacks can also shrink book value and make P/B look high.
EV/EBITDA
Enterprise value (EV) is market cap plus debt minus cash, roughly what it would cost to buy the whole business including its obligations. EBITDA is earnings before interest, taxes, depreciation and amortization.
Because EV includes debt, EV/EBITDA allows fairer comparisons between companies with different capital structures, which is why it is common in mergers and in capital-heavy sectors such as telecoms, energy and industrials. Its weakness is that EBITDA ignores depreciation, and for businesses that must keep replacing equipment, depreciation is a real and recurring cost.
Free cash flow yield
Free cash flow is operating cash flow minus capital expenditures. Dividing it by market cap gives free cash flow yield, a measure of how much cash the business generates relative to its price. Many investors trust it more than P/E because cash is harder to manipulate than accounting profit. It can, however, swing from year to year with large investment projects.
Dividend yield and payout ratio
Dividend yield is the annual dividend per share divided by the price. A very high yield is often a warning rather than a gift: it may mean the share price has fallen because investors expect a cut. The payout ratio, dividends divided by earnings (or by free cash flow), shows how much room the company has to keep paying.
Market-level valuation
The same ratios can be applied to an entire index. The S&P 500's forward P/E is widely quoted in market commentary, and some investors follow the cyclically adjusted P/E (CAPE), popularized by economist Robert Shiller, which divides price by average inflation-adjusted earnings over the previous ten years to smooth out the business cycle.
Market-level ratios have a mixed record as timing tools. High readings have historically been associated with lower long-run returns on average, but markets can stay expensive or cheap by these measures for many years, and changes in accounting, sector mix and interest rates make comparisons with past decades imperfect. They are best read as a description of the starting point rather than a signal to act.
Quick comparison
| Ratio | Formula | Most useful for | Main blind spot |
|---|---|---|---|
| P/E | Price ÷ EPS | Profitable, stable companies | Losses, cyclical peaks, one-off items |
| PEG | P/E ÷ growth rate | Comparing growth companies | Relies on growth forecasts |
| P/S | Market cap ÷ revenue | Unprofitable or early-stage firms | Ignores margins |
| P/B | Market cap ÷ book equity | Banks, insurers, asset-heavy firms | Intangible assets, buybacks |
| EV/EBITDA | (Market cap + debt − cash) ÷ EBITDA | Companies with different debt levels | Ignores capital spending needs |
| FCF yield | Free cash flow ÷ market cap | Mature cash generators | Lumpy investment years |
Using ratios sensibly
A few habits make valuation ratios far more useful:
- Compare like with like. Measure a company against close competitors and against its own 5- or 10-year history, not against the whole market.
- Use more than one ratio. If P/E looks cheap but EV/EBITDA does not, the difference is usually debt, and that is worth understanding.
- Ask why it is cheap. Markets are not always right, but a low multiple usually reflects a real concern: slowing growth, competitive pressure, regulation or a heavy debt load.
- Check the inputs. Note whether figures are trailing or forward, GAAP or adjusted, and from which data provider.
- Remember the market context. When interest rates are low, investors have historically been willing to pay higher multiples for future earnings; when rates rise, the same earnings tend to be valued less generously.
Valuation ratios are a way to frame questions, not to answer them. The answer comes from understanding the business behind the numbers: how it makes money, how durable that is, and what could change it.
This article is for education only and is not investment advice.
Frequently asked questions
What is a good P/E ratio?
There is no single good number. A P/E only means something compared with the company's own history, its competitors and the wider market, and fast-growing businesses usually carry higher multiples than mature ones. A low P/E can signal a bargain or a business the market expects to shrink.
What is the difference between trailing and forward P/E?
Trailing P/E divides the share price by earnings over the past 12 months, which are actual reported figures. Forward P/E uses analysts' estimates for the next 12 months or fiscal year, which reflect expectations but may prove wrong. Comparing the two shows whether earnings are expected to rise or fall.
Why do analysts use EV/EBITDA instead of P/E?
Enterprise value includes debt and subtracts cash, so EV/EBITDA lets you compare companies with very different amounts of borrowing. EBITDA also ignores depreciation and tax differences. The trade-off is that EBITDA leaves out real costs such as equipment replacement, so it suits some industries better than others.
