🏷️ Valuation ratios: P/E, EV/EBITDA, free cash flow yield and more

🎯 In 30 seconds: A share price means nothing on its own. Valuation ratios compare the price with something the business produces: earnings (P/E), sales (P/S), assets (P/B), cash flow (free cash flow yield) or operating profit including debt (EV/EBITDA). They let you compare companies of different sizes. They do not tell you whether a stock will go up. A low ratio can mean a bargain, or it can mean the market expects trouble. You need the ratio and the reason behind it.

Why ratios exist

A $40 stock is not more expensive than a $30 stock. What matters is how much you pay for each dollar the business earns, sells or owns.

Ratios turn that into one number you can compare across companies and across time. They are the starting point of most fundamental analysis and most stock screens, including the site's Value screen.

Before the ratios, three building blocks from The three financial statements:

• Market capitalization (market cap): share price times shares outstanding. The price of the whole company's equity.
• Earnings per share (EPS): net income divided by shares outstanding.
• Enterprise value (EV): market cap plus debt minus cash. The price of the whole business, including what it owes. More on this below.

Two hypothetical companies

We will value two made-up companies side by side. Company X makes software for restaurants. Company Y makes steel parts for trucks. Both have 100 million shares.

Check the middle rows: EBITDA minus depreciation minus interest gives income before tax. For X: $600M - $290M - $60M = $250M. For Y: $650M - $120M - $180M = $350M. Then 20% tax.

P/E: price to earnings

P/E = share price / EPS. It answers: how many dollars do you pay for one dollar of yearly profit?

• Trailing P/E uses the last 12 months of actual EPS. Real numbers, but backward-looking.
• Forward P/E uses analysts' estimates for the next 12 months. Forward-looking, but estimates are often wrong.

On trailing P/E, Y looks almost twice as cheap. But look at the forward numbers. X's earnings are expected to grow from $2.00 to $2.40. Y's are expected to fall from $2.80 to $2.10. The gap shrinks a lot.

Flip P/E upside down and you get the earnings yield: EPS / price. X: $2.00 / $40 = 5.0%. Y: $2.80 / $30 = 9.3%. Earnings yield is handy for comparing a stock with a bond yield, since both are percentages.

P/E fails when earnings are zero or negative. A company that lost money has no meaningful P/E, so use sales or cash flow instead.

PEG: adding growth

PEG = P/E / expected annual EPS growth rate (in percent). It adjusts P/E for growth, since a fast-growing company deserves a higher P/E than a shrinking one.

X: analysts expect about 20% a year growth. PEG = 20.0 / 20 = 1.0. Y's earnings are expected to shrink, so its PEG is not meaningful.

A common rule of thumb treats a PEG near 1 as fair, but that is a convention, not a law. PEG depends entirely on a growth forecast, and long-range growth forecasts are some of the least reliable numbers in finance.

P/S and P/B: sales and assets

Price-to-sales (P/S) = market cap / revenue. X: $4,000M / $2,000M = 2.0. Y: $3,000M / $4,000M = 0.75.

P/S works for companies with no profit yet. The weakness: a dollar of sales is not a dollar of profit. A software company keeps far more of each sales dollar than a steel maker, so their P/S ratios are not directly comparable.

Price-to-book (P/B) = market cap / book value. Book value is shareholders' equity from the balance sheet: assets minus liabilities. X: $4,000M / $1,600M = 2.5. Y: $3,000M / $1,500M = 2.0.

P/B is most useful for banks and insurers, whose assets are mostly loans and securities with values close to their market prices. It is weak for software or brand-driven companies, whose most valuable assets (code, brands, people) barely show up on the balance sheet.

EV/EBITDA: counting the debt

P/E only looks at the shareholders' slice. But if you bought the whole company, you would also take on its debt and get its cash. Enterprise value captures that:

EV = market cap + debt - cash (plus preferred stock and minority interests, if any).

EBITDA is earnings before interest, taxes, depreciation and amortization. It is a rough measure of operating profit before financing choices and non-cash charges. It is not a GAAP figure, so companies can define it in different ways.

EV/EBITDA: X: $4,800M / $600M = 8.0. Y: $5,900M / $650M = 9.1.

Now Y, the "cheap" stock on P/E, is the more expensive one. Its heavy debt makes the equity look small, but anyone owning the business still has to deal with $3 billion of loans.

Free cash flow yield and dividend yield

Free cash flow (FCF) is cash from operations minus capital spending: the cash left for owners. FCF yield = free cash flow / market cap.

X: $240M / $4,000M = 6.0%. Y: $150M / $3,000M = 5.0%. X turns more of its profit into spare cash. Many analysts trust FCF more than EPS, because cash is harder to dress up than accounting profit.

Dividend yield = annual dividend per share / share price. X: $0.80 / $40 = 2.0%. Y: $1.50 / $30 = 5.0%.

Also check the payout ratio, dividends per share divided by EPS. Y pays $1.50 out of $2.80 of earnings today, 54%. If EPS falls to the expected $2.10, that becomes 71%, and Y's free cash flow of $1.50 per share would barely cover it. A high yield that the cash flow cannot support is a warning, not a gift. Dividends, splits and buybacks covers yield traps in detail.

Why a low P/E is not automatically cheap

The market is a crowd of buyers and sellers who mostly have the same numbers you do. When a P/E is low, the crowd usually has a reason. Common ones:

• Earnings are at a peak. Cyclical businesses (steel, autos, chemicals, airlines) earn the most at the top of the economic cycle. P/E looks lowest right before profits fall.
• One-time gains. Selling a building or winning a lawsuit can inflate one year's net income. Read the income statement for unusual lines.
• Heavy debt. As with Y, debt shrinks the equity value and makes P/E look low.
• A shrinking business. A company losing customers deserves a low multiple. A stock that keeps getting cheaper as its business declines is called a value trap.
• Accounting choices. Aggressive revenue recognition or low depreciation can lift EPS without lifting cash.

A practical procedure

1. Start with what the company does and how it makes money. The right ratio depends on the business.
2. Pull at least three ratios: one on earnings (P/E), one on cash (FCF yield) and one that includes debt (EV/EBITDA).
3. Compare each with the company's own five-year range and with two or three direct competitors.
4. If something looks cheap, write down why the market might be right. Peak earnings? Debt? A shrinking market?
5. Check whether trailing and forward numbers point the same way. Big gaps mean the market expects change.
6. Only then decide whether the price leaves room for error. That is the margin of safety, covered in Building a stock thesis.

One more limit to keep in mind: valuation tells you little about the next week or month. Expensive stocks can get more expensive for years and cheap ones can stay cheap. For short-term trades, valuation is context, not a timing signal. Growth vs value looks at how cheap and expensive stocks have behaved over long periods.

Try it

Use the Stock screener to pull five companies from one industry. For each, write down the price, trailing P/E, forward P/E and, if you can find them, debt and cash. Calculate enterprise value yourself. Rank the five by P/E, then by EV/EBITDA or EV/sales, and see whether the order changes. For any company that moves a lot, find the reason in its balance sheet.

Then check your work on X and Y: if Company Y paid off $1,000M of its debt using cash from a new share sale, what would happen to its EV? (Answer: debt falls by $1,000M but market cap rises roughly by the same amount from the new shares, so EV stays close to $5,900M. Only the split between owners and lenders changes.)

Sources

• Investor.gov (SEC): Price-earnings (P/E) ratio
• Investor.gov (SEC): Market capitalization
• SEC: Beginners' Guide to Financial Statements
• NYU Stern, Aswath Damodaran: PE ratio by sector (US)