Understand P/E, PEG, dividend payout, earnings per share, market cap, enterprise value, book value and the Graham number, and what each one leaves out. Flags the 4 mistakes that most often produce a plausible-but-wrong answer.
Key takeaways
- Every ratio compares price or value with one fundamental, so each answers a narrow question.
- P/E is price over earnings, and its inverse is the earnings yield.
- PEG adds a growth forecast, which is only as reliable as the forecast.
- Enterprise value adds debt and subtracts cash, so it compares companies with different borrowing.
- Use ratios as a screen and follow up with the filings and the business itself.
Ratios put price next to a fundamental
A share price on its own says little. Valuation ratios divide the price, or the value of the whole company, by something the business produces or owns: earnings, growth, book value or dividends. The result lets you compare a company with its own history and with similar businesses. No ratio decides whether to buy, and each one answers a narrow question.
Earnings per share is the starting point
Earnings per share is the profit available to common shareholders divided by the average number of shares. Net income of $50 million, less $2 million of preferred dividends, spread across 20 million shares gives $2.40 a share. Preferred dividends come out first because those holders are paid before common shareholders, and the average share count reflects buybacks and new issues during the year.
The price-to-earnings ratio
The P/E divides the share price by earnings per share. At $150 and $6 of earnings, it is 25, meaning the market pays $25 for each dollar of yearly profit. Flip it over and you get the earnings yield, 4 percent here, which compares with interest rates. A high P/E can reflect expected growth, and a low one can reflect trouble, so context decides.
Trailing and forward earnings
A trailing P/E uses the last twelve months of reported earnings, and a forward P/E uses an estimate of the next twelve. Forward figures depend on forecasts that may prove wrong. When you compare two companies, use the same basis for both, and remember that a one-time gain or loss can distort a single year's earnings.
The PEG ratio adds growth
The PEG divides the P/E by the expected earnings growth rate in percent. A P/E of 25 with 15 percent expected growth gives a PEG of about 1.7. The idea is that a higher P/E can be justified by faster growth. It is only as good as the growth estimate, which is a forecast, and it works poorly for slow-growth firms and for growth rates that cannot last.
Dividend payout and retention
The payout ratio is dividends per share divided by earnings per share. Paying $2.40 out of $6.00 of earnings is 40 percent, with 60 percent retained to reinvest. A payout near or above 100 percent means the dividend is not covered by profit and may be cut. A low payout leaves room to grow the dividend, though some growth companies pay none.
Market cap and enterprise value
Market capitalization is the share price times the number of shares, the market's value of the equity. Enterprise value adds the company's debt and subtracts its cash, giving the price of the whole business. Two companies with the same market cap can carry very different debt, and enterprise value shows the difference. Use it to compare firms with different capital structures.
Book value and price-to-book
Book value per share is the equity, less preferred equity, divided by common shares: what each share would hold if the assets were sold at their recorded values and the debts paid. The price-to-book ratio compares the price with that figure. It suits asset-heavy businesses such as banks and utilities, and it says little about companies whose value lies in software, brands or people.
The Graham number
Benjamin Graham's number is the square root of 22.5 times earnings per share times book value per share, where 22.5 is a P/E of 15 times a price-to-book of 1.5. It gives a ceiling on the price a defensive investor should pay. With $4 of earnings and $30 of book value it is about $52. It ignores growth and debt, so use it as a screen, not a target.
What ratios cannot tell you
Ratios describe the past and the present. They do not measure the quality of management, the strength of a competitive position or the risk of a change in the industry. They can also be distorted by accounting choices, one-time items and cyclical peaks. Use several ratios together, read the filings, and treat the output as a starting point for questions.
Worked with real numbers
What this looks like in the p/e ratio calculator
The guidance above is easier to judge against figures. Using the p/e ratio calculator worked example, moving share price from $120 to $180 changes the price-to-earnings ratio from 20.00× to 30.00×.
| Share price | Price-to-earnings ratio | Earnings yield |
|---|---|---|
| $120 | 20.00× | 5.0% |
| $135 | 22.50× | 4.4% |
| $150 | 25.00× | 4.0% |
| $165 | 27.50× | 3.6% |
| $180 | 30.00× | 3.3% |
Open the P/E Ratio Calculator to use your own numbers →
The inputs behind those figures
| Input | Value | Definition |
|---|---|---|
| Share price | $150 | Enter the share price used in this calculation. |
| Earnings per share (trailing 12 months) | $6.00 | Net income divided by shares outstanding, from the company's income statement. |
What goes wrong
Common mistakes
Each of these produces an answer that looks reasonable, which is why they survive review. To catch them in how to read stock valuation ratios, rerun the p/e ratio calculator with a different assumption and check whether the result moves in the direction the guidance predicts, since an error that survives that test is usually in one of the inputs and not in the arithmetic.
| The mistake | Why it misleads | Do this instead |
|---|---|---|
| Calling a low P/E cheap | Earnings may be about to fall, which makes a low ratio a warning instead of a bargain. | Look at the trend in earnings and the reasons behind the low multiple. |
| Comparing ratios across industries | Banks, utilities and software firms have very different normal ratios. | Compare a company with peers in the same industry and with its own history. |
| Leaving preferred dividends in EPS | Preferred holders are paid first, and the earnings left for common shareholders are smaller. | Subtract preferred dividends before dividing by common shares. |
| Reading the Graham number as a target price | It is a screening ceiling built for stable industrial companies and it ignores growth and debt. | Use it to filter, then look at the business behind the numbers. |
People also ask
Frequently asked questions
What is a good P/E ratio?
There is no single good number. Compare a stock with its own history and with similar companies, and ask why the multiple is high or low.
What is the PEG ratio?
The P/E divided by the expected annual earnings growth rate in percent. A PEG of about 1 is a rough reference point, and it depends on the growth forecast.
How do I calculate earnings per share?
Subtract preferred dividends from net income and divide by the average number of common shares. The EPS calculator shows the steps.
What is the difference between market cap and enterprise value?
Market cap is the value of the equity. Enterprise value adds debt and subtracts cash, so it is the price of the whole business.
What does the dividend payout ratio tell me?
The share of earnings paid out as dividends. A high payout leaves less cushion, and a low one leaves room to grow the dividend.
What is book value per share?
The equity available to common shareholders divided by the number of common shares, what each share would hold on paper.
Is the Graham number a reliable buy signal?
No. It is a screening ceiling that ignores growth and debt, so it is best used to narrow a list.
Why do some companies have no P/E ratio?
When a company has no profit, earnings per share is zero or negative and the ratio is not meaningful. Other measures, such as sales or book value, are used instead.
Should I buy a stock because its P/E is lower than the market's?
Not by itself. A lower multiple may reflect slower growth or higher risk, so compare with similar companies and look at why the price is what it is.
Which input moves the price-to-earnings ratio most in the p/e ratio calculator?
Ranked by how far each moves the price-to-earnings ratio across the range tested: share price (5.00×, 20%) and earnings per share (trailing 12 months) (5.05×, 20%).
If I double share price in the p/e ratio calculator, does the price-to-earnings ratio double?
Doubling it from $150 to $300 takes the price-to-earnings ratio from 25.00× to 50.00×, which is 2.00 times the worked-example figure. So the result scales almost exactly in proportion. Halving it to $75 gives 12.50×.