What are the main valuation ratios?

Think of them as a toolbox, as in the drawing at the top: each tool fits a job, and none fits every job. The list below uses one hypothetical company with a share price of $40 and 100 million shares, a market cap of $4 billion, plus revenue of $2 billion, net income of $200 million (EPS of $2.00) and shareholders’ equity, or book value, of $1.6 billion.

  • P/E = price ÷ EPS: $40 ÷ $2.00 = 20. The default for steadily profitable companies; earnings per share explains what goes into the EPS.
  • P/S (price-to-sales) = market cap ÷ revenue: $4 billion ÷ $2 billion = 2.0.
  • P/B (price-to-book) = market cap ÷ book value, or price ÷ book value per share: $4 billion ÷ $1.6 billion = 2.5.
  • EV/EBITDA = enterprise value ÷ EBITDA (earnings before interest, taxes, depreciation and amortization). With $1 billion of debt, $400 million of cash and $460 million of EBITDA: ($4B + $1B − $0.4B) ÷ $0.46B = 10.
  • PEG = P/E ÷ expected EPS growth rate: a P/E of 20 with 10% expected growth gives 2.0. See the Peter Lynch strategy.
  • Earnings yield (E/P) = EPS ÷ price, the P/E upside down: $2.00 ÷ $40 = 5%.

Which valuation ratio should you use?

Match the ratio to the business. A useful habit is to check two or three ratios and see whether they tell the same story before trusting any one of them.

  • Unprofitable or early-stage growth companies: P/S, because there are no earnings to divide by. Sales are not profit, so read P/S together with margins and the path to profit; how to pick growth stocks uses it in a valuation check.
  • Banks and insurers: P/B. Their assets and liabilities are mostly financial, such as loans, securities and deposits, so book value says more about them than about most companies. For software or brand-driven companies, whose key assets barely appear on the balance sheet, P/B says little.
  • Capital-heavy or indebted companies, such as telecoms, utilities and industrials: EV/EBITDA, because it includes debt and is not affected by differences in interest costs and depreciation.
  • Steady, profitable companies: P/E, with PEG to add growth to the picture.
  • Comparing a stock with bonds: earnings yield, keeping in mind that most earnings are not paid out to you like interest.

What is enterprise value, and why use EV/EBITDA?

Market cap is the price of the shares. Enterprise value (EV) is closer to the price of the whole business: market cap + debt − cash. A buyer who takes over a company also takes on its debt and gets its cash, so two companies with the same market cap can cost very different amounts. Some versions also add preferred stock and minority interests.

In the drawing below, both hypothetical companies have a $1,000 million market cap and $100 million of EBITDA. Company A has no debt and $200 million of cash: EV $800 million, EV/EBITDA 8. Company B has $600 million of debt and $100 million of cash: EV $1,500 million, EV/EBITDA 15. On market cap they look identical; on EV, B costs almost twice as much.

EBITDA has blind spots: it ignores capital spending, a real cost for a capital-heavy business, and interest, which an indebted company must pay. Check free cash flow alongside it.

Turn your phone sideways to read the drawing. Tap to close.

Two hand-drawn horizontal bars in $ millions: for Company A, a gray 1,000 market cap block with a green hatched −200 cash block over its end gives EV 800 and EV/EBITDA 8; for Company B, the same 1,000 block plus a red +600 debt block, with a green hatched −100 cash block over its end, gives EV 1,500 and EV/EBITDA 15; a highlighted formula reads EV = market cap + debt − cash, and a note reads same market cap, same EBITDA, different EV.

How to compare valuation ratios: same sector, same yardstick

A ratio means little alone. Industries differ in growth, margins and the capital they need, so their usual multiples differ too. In the drawing below, the same EV/EBITDA of 14 sits above every peer in hypothetical Sector X, where peers trade between 6 and 10, and below every peer in Sector Y, where they trade between 18 and 26. The number is identical; the conclusion is the opposite.

Compare a company with its direct peers and with its own history, measured the same way: trailing with trailing, forward with forward, the same definition of debt and the same period. A ratio far from its peers is a question, not an answer: the company may be cheap because its business is shrinking, the value trap described in growth vs value stocks, or expensive because it grows faster.

Turn your phone sideways to read the drawing. Tap to close.

Two hand-drawn EV/EBITDA number lines from 0 to 30 for hypothetical sectors: Sector X peers are five dots between 6 and 10, Sector Y peers five dots between 18 and 26; a yellow diamond at 14 on both lines, joined by a dashed line, is labeled expensive vs peers on the first line and cheap vs peers on the second; a highlighted note reads compare within a sector.

The limits of valuation ratios

Every ratio is a snapshot of today’s price against one number, usually from the past year or from analysts’ forecasts. None tells you what the business will earn next, and each can be distorted:

  • One-off gains or charges move earnings, and with them the P/E and the earnings yield.
  • Buybacks and write-downs shrink book value and push P/B up without any change in the business.
  • Forward ratios rest on estimates, which are often wrong, especially for young or cyclical companies.
  • Low multiples can stay low for years, and high ones can keep rising.

How to use valuation ratios in practice

Use ratios to screen and to ask better questions, then study the business behind them, as the fundamental analysis for beginners guide describes: growth, margins, debt, cash flow and competitive position. A cheap ratio on a growing, well-financed business is worth a closer look; a cheap ratio on shrinking sales usually is not a bargain.

Keep a short, consistent routine: the same two or three ratios, from the same source, compared with the same peers every time. Changing the yardstick from one stock to the next makes almost anything look cheap.