Updated 5/20/2024
One of the hardest things for a new investor is understanding the math of investing and what the different valuation ratios mean.
It can be overwhelming, but don’t worry—I’m here to help break it down in a very simple way and will even point you to a tool to get you started on your investing journey!
When you’re looking to value a company, you need to understand its various financials and how it is valued. If you don’t understand some of the basic valuation methods, it will be very, very hard for you to understand why that company is being valued that way and whether it’s even a good value at all!
Andrew and Dave recently discussed some different valuation ratios on the Investing for Beginners Podcast, all of which I think are key staples for any investor to understand, so let’s break them down a bit further!
Click to jump to a section:
Valuation Ratio #1 – Price/Earnings
This is by far the most common price valuation method you will see. First, let’s take a look at the formula:
P/E = Price/Earnings
Another way to say this formula is:
P/E = Market Cap/Total Earnings
or
P/E = Share Price/EPS (Earnings per share)
Price/Earnings, or P/E, is a very simple formula (as are all of these valuation ratios) that essentially tells you the price you have to pay for every dollar of the company’s earnings.
For instance, if the company’s market cap is $1 billion and its earnings are $100 million, then you simply take $1 billion/$100 million and get 10.
That means that you’re paying a 10-times multiple for the company you’re purchasing. But what does that actually mean? Is 10 good?
Well, as with many things in investing, it depends! If I had to just answer yes or no, I’d say yes. In fact, Benjamin Graham says that he targets a P/E under 15, so 10 is significantly lower than that. But just because the P/E is low doesn’t mean it’s a good buy!
P/E is nothing more than a simple valuation ratio that many people use as an initial look to think about the company and how they’re valued. In today’s world, it seems like P/E matters even less because companies can skyrocket at any time.
There are companies like Tesla that have extremely high P/E ratios. Currently, Tesla sits at ~45 which is already high, but has seen values higher than 70 in the past.
I think this is ridiculous, but I am also starting to loosen my “death grip” on these valuation ratios that somewhat put me in a box. Some valuation methods might be a little bit outdated or maybe even less pertinent than they used to be, and it’s important to keep up with the times, which leads to my next valuation ratio.
Valuation Ratio #2 – Price/Book
The next ratio is Price/Book, or P/B. Truth be told, this is a ratio that makes a ton of sense to me but just feels a little bit…well…outdated.
Similar to P/E, P/B is a very simple formula to calculate:
Price/Book = Market Cap/Book Value
We’ve already discussed how “Price” is a company’s market cap, so the new thing we need to find out is its book value. Andrew describes book value as “how much shareholder’s equity is on the books for the business. This doesn’t necessarily equal market value, as various equity/ assets can have different earning power and value.”
In essence, what you’re trying to do with this ratio is to find the value of the assets that the company has currently. The goal behind this is because if the company was forced into bankruptcy and had to liquidate all of their assets then they would be able to sell a certain amount of them off to give some cash back to shareholders.
Example
So, let’s go through a quick example:
If a company has a market cap of $1 billion and a book value of $200 million, then its P/B is 5. That’s great, but what is a good P/B?
Many people (especially value investors) try to keep a P/B of 1 or less. Doing so means that the company is currently trading at a price lower than the amount that it could recoup simply by selling its assets.
Nothing else. No more sales or expansion. Just stop and sell everything, and you’d have more cash than your company’s market cap.
Honestly, this makes a ton of sense to me, but there is one major issue – it’s outdated! So many companies don’t have great infrastructure. That’s not what makes these newer companies great – it’s their technology. Companies that typically have a lot of infrastructure, will benefit from this ratio.
I’m trying to walk a fine line and not generalize because I do think that there are a lot of great companies that you can find by using the P/B, but I think if you’re using it in your analysis, then you’re also going to weed a lot of companies out of your stock screen that are great companies with less of an asset-focused approach.
Valuation Ratio #3 – Price/Sales or Price/Revenue
Personally, this is my favorite of the four valuation strategies. This is a very simple ratio to calculate, just as the two above were, with the change being that you’re simply going to look at the sales/revenue of the company for the valuation:
Price/Sales = Price/Revenue = Market Cap/(Sales/Revenue)
I love P/S (Price/Sales) so much, honestly, for a very similar reason that I am not all onboard with P/B—I think that the world is changing. We’re in this weird time where earnings almost don’t matter for companies.
Of course, at the end of the day, businesses are around to make money and that’s essentially the only reason, but I hear me out.
We’re quickly moving into this new world where so many companies are technology companies. I mean, think about it:
- Tesla, who makes cars, is a tech company
- Dominos Pizza, who makes food, is considered tech by many because of their app and delivery platform
- Uber, a glorified taxi service, is pure tech
These companies are taking things that are not technically advanced—cars, food, and taxis—and turning them into tech-based companies.
Sure, of course we have to apply some sort of valuation to them, and that’s where I like to use P/S. I have no problem with a company shelling out a ton of cash to invest into its platform and become more tech-savvy, but that’s going to come at a major cost, likely being lower earnings and hurting their P/E.
Honestly, I don’t think I care about the company’s assets. I want to see a company that’s willing to spend money on R&D continue to adapt technologically, and keep driving revenues up and up. If that company can continue to grow its sales and have a path to profitability, then I might be willing to take a flier on that company.
Personally, I think that by benchmarking a company based on its sales, I can likely find a way to make more money than if I was strictly looking at just value. I know that this goes against everything that value investors think and feel and even against my own thoughts, but I think that by doing this and even playing a bit of a momentum investing game by preying off the behavioral finance tendencies of others, I can make some rapid gains.
Many people will look for a P/S of 1, or maybe a max of 2, but I might be willing to flex this out a bit if I 1000% am onboard with the company and where I think they’re going.
As I mentioned, when I do this, it’s definitely more of speculation rather than investing, so I make sure to spend even more time researching the company to be sure that I am happy with the risk that I am accepting prior to investing.
I still will really only focus on the long-term (for the most part) because the data shows that the long-term puts the pounding on those short-term investors…looking at you Davey Day Trader!
Valuation Ratio #4 – PEG Ratio
The last ratio that I want to talk about is the PEG Ratio. I really don’t want to spend a ton of time on the details of this because Dave wrote an article that’s 100 times better than I could explain PEG, but essentially you’re taking that same P/E ratio that I described above and then applying it to a growth rate of historical earnings.
PEG = (Price/Earnings)/Earnings Growth Rate
So, if the P/E is 20, and the earnings growth rate is 10%, then the PEG ratio is 2 (20/10). The goal is to have a PEG at 1 or less because that would mean that the company’s share price/market cap is growing slower than they are growing their earnings, meaning that they’re becoming more and more undervalued by the second!
Andrew, being the incredible person that he is, created a historical look at a ton of companies and compared their returns based off how their PEG ratios were from 2000 – 2018. For instance, take a look below:
What this means is that when 3M, one of the GOAT dividend payers and a Dividend King at that, has a PEG that’s less than 0, the average return was 1.95%. Anything under 1 meant a return of 1.97%. Between 1 and 2 was a negative return of -3.79%, but then a PEG over 2 was 6.5%!
Based solely on doing a quick scan of Andrew’s (free) sheet, I think that this is likely uncommon and the lower the PEG, the higher the returns will be, which makes a lot of sense because the company is undervalued!
Summary
So, let’s tie it together – all four of these valuation ratios are great tools to evaluate a company, but it’s also imperative to understand the differences between the companies that you’re looking at. For instance, a tech company might not have the same P/B as a railroad or an oil company. A new company that’s fresh off their IPO might have a much higher P/S than a Dividend King that has been in business for 50+ years.
Make sure that you’re comparing apples to apples and looking at peers when you’re doing your analysis.
Just for fun, I decided to run a stock screener on finviz with the following criteria:
- P/E < 15
- P/B < 1
- P/S < 1
- PEG < 1
Believe it or not, there are 70 companies that meet this very strict criteria!
Click to zoomI mean, I just changed the P/E to ‘under 5’, and there were even 36 companies that met that criteria!
I started looking at them, and honestly, there were a lot of penny stocks, lol, but I still think that these results were very interesting and quite possibly a good thing to look at further!
At the end of the day, if you’re a new investor, I recommend that you try to understand these four ratios. I started with these four, and they formed a great basis for my investing knowledge.
If you can understand these methods at first, you’re giving yourself a great foundation of market cap, earnings, book value, sales, and growth. Those are all extremely important parts of being a successful investor.
Once you have those mastered, then you can start to move on to some different financials that are worth paying attention to such as the quick/current ratios for short-term liquidity and identifying companies with great management by using ROIC, but only once you’ve mastered these four first!
If you skip these methods, you’re simply robbing yourself! Take the time and learn the right way!
