Five Key Financial Ratios for Stock Analysis

There are several stock ratios, but these five are so fundamental to analyzing stocks that you should thoroughly understand them all and how they can help give you direction when trying to figure a stock's "value." You're probably asking yourself: Valuation relative to what? Well, that's the point.

You might want to view a stock's value from many different angles to make sure you have all the basics covered. And that's what these five ratios are designed to do.

The price-to-earnings (P/E) ratio is quite possibly the most heavily used stock ratio. The P/E ratio—also called the "multiple"—tells you how much investors are willing to pay for a stock relative to its per-share earnings.

Computing the P/E is simple: just divide the stock's share price by its earnings per share (EPS). For example, if a stock has a P/E ratio of 20, it means investors are willing to pay up to 20 times its EPS to own it. But is that too much or too little? Expensive or cheap?

Ultimately, it can depend on what a company is capable of accomplishing in terms of future earnings. You can compare a stock's P/E to that of the S&P 500^® historical average return, which was almost 12% over the last 10 years, as of November 2022 (assuming dividends are reinvested). During the 11-year bull market that began in March 2009, the index's P/E ranged from 13.5 to nearly 124, ending at about 23 in March 2020. The limit to the P/E ratio's effectiveness is that it can't really tell you much beyond what investors are willing to pay for the stock now.

For example, if a company with a P/E ratio of 35 has a higher rate of growth than a company with a P/E ratio of 10, then shares of the company with the higher ratio might actually be considered cheaper than shares of the company trading at the lower ratio. And this brings us to the next ratio.

While it's not as popular as its P/E relative, the price/earnings-to-growth (PEG) ratio can provide a more comprehensive and clearer picture of a stock's future growth prospects.

You may know a stock's P/E ratio, but how does such a number stand relative to its projected growth rate? A company's P/E may seem "cheap," but if the company doesn't grow, what's the point of holding on to a stock with a low P/E?

With the PEG ratio, you're comparing the P/E to the analyst consensus estimate of projected earnings, which typically project as early as quarterly to as long as five years.

The PEG is derived by dividing the P/E ratio by projected EPS growth. For example, a stock with a P/E of 18 and a percentage growth rate of 15% would carry a PEG of 1.2. So, how should you read this number? Typically, stocks with a PEG ratio of less than 1 are considered undervalued.

The growth component is important because investors don't want to buy something that won't increase in value. What investors tend to look for when buying shares with a low PEG ratio is a history of growth in combination with projected growth, which can help validate an undervalued PEG ratio.

Some companies might have strong quarterly sales but weak earnings, perhaps because they ended up spending a good portion of their revenue. Some investors are willing to forego profits now for potentially stronger returns in the future. They understand that certain companies may need to spend their cash and quarterly sales profits to build a bigger and better company for the future. The important thing these investors focus on here is sales.

The price-to-sales (P/S) ratio shows how much investors are willing to pay above a company's gross revenue, whereas investors focused on earnings are looking at revenue minus liabilities. Revenue may not be considered as "solid" a figure as earnings for a valuation, but sales are generally subject to less manipulation by management than earnings numbers. Although earnings can be affected by various expenses, what a company makes in sales is quite straightforward.

The P/S ratio is calculated by dividing the stock price by sales per share. For example, a firm with $500 million in sales with 100 million shares outstanding would post sales per share of $5. If the stock price is $10 per share, the P/S ratio is 2. 

The P/S ratio helps investors understand the relationship between a company's current stock price and its annual sales. If a P/S ratio is .53, the ratio shows that investors are paying $0.53 per share for every dollar the company makes in sales.

How much is a company's stock worth relative to its net asset value (also called "book value")? That's what the price-to-book (P/B) ratio indicates. On the surface, it's an effective metric that can compare a stock's market capitalization to what it owns versus what it owes. But it's not always that simple.

Figuring what a company's assets are worth can be a big sticking point. Depending on the industry, many companies’ asset costs are priced not according to market value but their value carried at the time of acquisition. For example, if a well-established company purchased real estate decades ago, the value of that property on the firm's books may be decades old, not marked-to-market. To find a company's real book value—which also is called "shareholders' equity"—you might have to dig a lot deeper, beyond the books. The P/B ratio is best suited to large, capital-intensive companies, such as automakers, rather than companies with intangible assets, such as software firms where much of the value is based on patents or other intellectual property that's not carried on the books as an asset.

A P/B ratio of 1 indicates the company's shares are trading in line with its book value. A P/B higher than 1 suggests the company is trading at a premium to book value, and lower than 1 indicates a stock that may be undervalued relative to the company's assets. To get the P/B ratio, divide the stock price by the book value per share. A company with 100 million outstanding shares, assets of $800 million, and debt liabilities of $125 million would carry a book value of $675 million, or $6.75 per share. If that stock traded at $5, the resulting P/B ratio of .74 would suggest that the stock may be undervalued.

Similar to a company's book value, we also reverse the term for this last ratio, seeking to find out what a company owes relative to what it owns. The calculation is simple, and the figures for a firm's total debt and shareholders' equity can be found on the consolidated balance sheet.

Generally, investors prefer the debt-to-equity (D/E) ratio to be less than 1. A ratio of 2 or higher might be interpreted as carrying more risk. But it also depends on the industry. Big industrial energy and mining companies, for example, tend to carry more debt than businesses in other industries. That's why investors typically compare a stock's D/E ratio to the D/E of other companies in the same industry.

A high D/E ratio indicates a company has borrowed heavily. That could mean the company is leveraging its assets to finance growth, but it also might signal the company is unprofitable and is surviving by borrowing rather than generating revenue. The question investors want to consider is whether the debt is increasing earnings by more than the cost of the debt, or whether the debt is weighing the firm down with loan payments and other liabilities.

Using the same example as in the P/B ratio, the company with 100 million outstanding shares, assets of $800 million and debt liabilities of $125 million, would post shareholders' equity (book value) of $675 million. Dividing the total liabilities by shareholders' equity results in a D/E ratio of .19, indicating a company that's holding very little debt and most likely financing its growth through earnings.

Analyzing the value of a stock isn't all that simple. Calculating ratios alone won't give you a clear answer, but if you treat them as coordinates on a map, they can help point you in the right direction. As with every map, you can't always see the road or weather conditions. That's when you'll have to make your own judgments and decide whether an opportunity is favorable or too risky.

These five key financial ratios should help you get started. Remember, although they can't reveal everything that's important about a company, it helps to see just enough of the road ahead to decide where to go and whether to speed up or slow down.