Stock Valuation Using Valuation Ratios: How to Assess If a Stock Is Overvalued or Undervalued
Valuation ratios are a critical part of any investor’s toolkit. They help determine whether a stock is trading at a fair price relative to its earnings, book value, sales, or growth potential. But interpreting them requires nuance—especially in different market conditions and across sectors. In this guide, we unpack the key valuation ratios, how they are used, and how they fit into a broader investment thesis.
What Are Valuation Ratios?
Valuation ratios compare a company’s market value (usually price per share or market capitalization) to a fundamental metric like earnings, revenue, or book value. They are used to:
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Screen for cheap or expensive stocks
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Compare similar companies
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Support buy, hold, or sell decisions
Key Valuation Ratios Explained
1. Price-to-Earnings Ratio (P/E)
Formula: Price per Share / Earnings per Share (EPS)
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A high P/E may indicate future growth expectations—or overvaluation.
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A low P/E may indicate undervaluation—or low growth prospects.
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Trailing P/E uses past 12 months; Forward P/E uses forecast earnings.
Example:
A high-growth tech stock may trade at 35x earnings, while a utility may sit around 12x.
2. Price-to-Earnings-to-Growth (PEG)
Formula: P/E Ratio / Expected EPS Growth Rate
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Adjusts the P/E ratio by factoring in growth.
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PEG < 1.0 suggests undervaluation (growth not priced in).
Example:
A company with a P/E of 20 and growth of 25% has a PEG of 0.8 — potentially attractive.
3. Price-to-Book Ratio (P/B)
Formula: Market Price per Share / Book Value per Share
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Measures valuation relative to net assets.
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P/B < 1.0 may suggest deep value, especially in asset-heavy sectors.
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More relevant for banks, insurers, and industrials.
Example:
A bank with a P/B of 0.9 might be undervalued—but also could signal underlying risk.
4. Enterprise Value to EBITDA (EV/EBITDA)
Formula: (Market Cap + Debt – Cash) / EBITDA
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Common in M&A, private equity, and institutional valuation.
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Strips away capital structure differences.
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A lower ratio generally means better value.
Example:
EV/EBITDA of 8x is often seen as a baseline. Tech growth names may trade at 15x+, mature industrials at 7x.
5. Price-to-Sales Ratio (P/S)
Formula: Market Cap / Total Revenue
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Useful when a company is not yet profitable (no earnings).
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Often used in early-stage tech or biotech firms.
Example:
A SaaS firm with high growth but no profit may trade at 8x sales. Compare against sector peers.
Market Phase Interpretation
📈 Bull Market
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Investors tolerate higher valuations, especially for growth and momentum names.
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PEG becomes more relevant than P/E.
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Price-to-sales ratios may stretch well above historical norms.
📉 Bear Market
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Valuations compress. P/E ratios tend to contract.
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Defensive sectors (utilities, healthcare) favored for low P/E and stable P/B.
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EV/EBITDA and FCF yield often come into sharper focus.
✨ Transition Markets
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Investors reprice risk: stocks with strong valuation support may rebound first.
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Companies with sustainable margins and moderate valuation often lead recoveries.
Sector Considerations and Benchmarks
Common Pitfalls in Valuation Analysis
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Ignoring growth rate: A stock can be cheap for a reason (value trap)
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Sector mismatch: Comparing a bank’s P/E to a SaaS firm is misleading
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Temporary distortions: One-off earnings can skew P/E or EV/EBITDA
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Ignoring leverage: Market cap doesn’t account for debt; use EV-based metrics
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Chasing low ratios blindly: Quality and context matter
Case Study: Two Stocks, Same P/E
Stock A (Retailer)
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P/E: 18x
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EPS Growth: 5%
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PEG: 3.6
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P/B: 1.2
Stock B (Cloud Software)
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P/E: 18x
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EPS Growth: 30%
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PEG: 0.6
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P/B: 12
Stock B looks expensive on P/B but much cheaper on PEG. For a growth investor, it might offer far better upside.
Pro Tips for Smart Valuation Analysis
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Combine multiple ratios for a fuller picture
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Always cross-reference with growth, margins, and balance sheet
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Recheck ratios post-earnings; forward P/E shifts fast
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Contextualize with market conditions and rate environment
We at ForexLive.com (evolving to investingLive.com later this year) are continuing to educate investors. In this case, mastering valuation ratios empowers you to make better decisions about when to buy, hold, or pass. Markets are dynamic, but disciplined valuation thinking can ground you amid the noise.
Price tells you what you pay. Valuation ratios help you understand what you’re actually getting.
This article was written by Itai Levitan at www.forexlive.com.