Fundamental analysis · Fundamentals
Valuation Ratios
Is the stock cheap or expensive? P/E, P/S and PEG explained.
▶ Watch the free video lesson with TomWhat it is
Valuation ratios compare a company's price to what it produces. The price-to-earnings ratio (P/E) tells you how many dollars you pay for one dollar of annual profit. P/S helps with companies that are not yet profitable, and PEG adjusts P/E for growth. Ratios only make sense when compared with peers in the same sector.
How it works
- P/E = share price ÷ earnings per share. A $100 stock earning $5 per share has a P/E of 20.
- A high P/E means investors expect strong growth; a low P/E can mean value, or a business in trouble.
- P/S = market value ÷ annual sales. Useful when there are no profits yet.
- PEG = P/E ÷ growth rate. Around 1 is often considered fair for growth.
- Always compare within the same sector: tech and utilities have very different normal ranges.
The rules
| Entry | Prefer leaders with growth at a reasonable PEG, then time with a chart setup. |
|---|---|
| Stop loss | From the chart, not from valuation. |
| Exit | Technical exit; valuation is not a timing tool. |
| Filter | Compare ratios with sector peers only. |
Pros
- Quick way to compare companies
- Highlights extreme optimism or pessimism
- Easy to find on any finance site
Cons
- Cheap stocks can stay cheap
- Expensive stocks can keep rising
- Accounting can distort earnings
Common mistakes
- Comparing P/E across different sectors
- Buying only because the P/E is low
- Using valuation to time entries
Lesson transcript
Part three: valuation ratios. When you buy a stock, you're buying a piece of a business. Valuation asks a simple question: am I paying a fair price for what this business produces? The most famous ratio is the price to earnings ratio, the P E. Take the share price and divide it by the earnings per share. A one hundred dollar stock that earns five dollars per share has a P E of twenty. You're paying twenty dollars for every dollar of annual profit. But a P E means nothing on its own. You must compare it with similar companies. Here are four companies in the same sector. Company C looks expensive, but it's also growing the fastest. That's why we use the peg ratio. Divide the P E by the growth rate. Company C has a P E of thirty four, but grows thirty four percent a year, so its peg is one. Company A looks cheap, but barely grows, so its peg is actually higher. Cheap isn't always a bargain. For young companies with no profits yet, we use price to sales instead. And always compare inside the same sector. A software company and a utility company live in completely different worlds. Recap. P E tells you what you pay for profits. Peg adjusts for growth. Compare within the sector. And remember, valuation tells you what to buy, not when. The chart still decides your entry. Next, the economic calendar.
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