Key Takeaways
- The P/E ratio compares a stock's price to its earnings per share — average P/E ratios range between 15-25 depending on company and industry
- Price-to-book ratios above 5:1 may signal overvaluation; the S&P 500 average is approximately 3:1
- Growth companies typically have higher P/E ratios but lower dividend yields, while value companies show the opposite pattern
- Liquidity ratios (current ratio, quick ratio) measure a company's ability to meet short-term obligations
- ROE (Return on Equity) measures how effectively management generates profits from shareholders' equity
Financial Ratios and Valuation
Financial ratios are the foundation of fundamental analysis. Investment advisers use these metrics to evaluate whether securities are fairly valued and to compare investment opportunities across different companies and industries.
Valuation Ratios
Valuation ratios compare a company's stock price to various financial metrics to determine if the stock is overvalued, undervalued, or fairly priced.
Price-to-Earnings (P/E) Ratio
The P/E ratio is the most widely used valuation metric. It compares a company's stock price to its earnings per share.
Formula: P/E Ratio = Market Price per Share / Earnings per Share (EPS)
| P/E Level | Interpretation | Typical Companies |
|---|---|---|
| High (>25) | May be overvalued, or high growth expected | Technology, biotech |
| Average (15-25) | Fairly valued | Mature, stable companies |
| Low (<15) | May be undervalued, or slow growth expected | Utilities, financials |
Example: A stock trades at $60 with EPS of $3.00. The P/E ratio is $60 / $3 = 20. This means investors are paying $20 for every $1 of annual earnings.
Growth vs. Value Companies
| Characteristic | Growth Companies | Value Companies |
|---|---|---|
| P/E Ratio | Higher | Lower |
| Dividend Yield | Low or none | Higher |
| Investment Return | Capital appreciation | Dividends + modest appreciation |
| Earnings | Reinvested for expansion | Distributed to shareholders |
Price-to-Book (P/B) Ratio
The P/B ratio compares a company's market price to its book value (accounting value of assets minus liabilities).
Formula: P/B Ratio = Market Price per Share / Book Value per Share
| P/B Level | Interpretation |
|---|---|
| Above 5:1 | May signal overvaluation |
| Near 3:1 | Average for S&P 500 companies |
| Below 1:1 | Stock trading below asset value; may be undervalued or distressed |
Earnings Per Share (EPS)
EPS measures profitability on a per-share basis.
Formula: EPS = Net Earnings / Shares Outstanding
EPS is a key input for calculating P/E ratios and is reported quarterly by public companies.
Profitability Ratios
These ratios measure how effectively a company generates profits.
| Ratio | Formula | What It Measures |
|---|---|---|
| Return on Equity (ROE) | Net Income / Shareholders' Equity | Profit generated per dollar of equity |
| Return on Assets (ROA) | Net Income / Total Assets | How efficiently assets generate profits |
| Profit Margin | Net Income / Revenue | Percentage of revenue kept as profit |
ROE in Practice
A company with $10 million in net income and $50 million in shareholders' equity has an ROE of 20%. This means the company generates 20 cents of profit for every dollar of equity.
Liquidity Ratios
Liquidity ratios measure a company's ability to meet short-term obligations.
| Ratio | Formula | Healthy Level |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | >1.0 (higher is better) |
| Quick Ratio | (Current Assets - Inventory) / Current Liabilities | >1.0 |
The quick ratio is more conservative because it excludes inventory, which may not be quickly convertible to cash.
Dividend-Related Ratios
| Ratio | Formula | Use |
|---|---|---|
| Dividend Yield | Annual Dividend / Stock Price | Current income return |
| Dividend Payout Ratio | Dividends Paid / Net Income | Portion of earnings distributed |
Example: A stock priced at $40 pays a $2 annual dividend. Dividend yield = $2 / $40 = 5%.
Exam Tip: The P/E ratio is the most commonly tested valuation metric. Remember: high P/E = growth expectations or overvaluation; low P/E = value stock or distressed company. Growth companies have high P/E and low dividends; value companies have low P/E and high dividends.
A stock trades at $50 with EPS of $2.50. What is the P/E ratio?
Which type of company would typically have a HIGH P/E ratio and LOW dividend yield?
A company has a price-to-book ratio of 0.8. This most likely indicates:
1.2 Time Value of Money
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