How to Value a Stock - P/E Ratio, P/S Ratio, and PEG Ratio

In this FAQ we’re going to walk through how to value a stock so you know what you’re buying.

0:16 - How to value a stock
0:26 - P/E ratio
1:56 - Price to sales ratio
3:36 - PEG ratio

One of the most common approaches to valuing a company is the P/E Ratio.

This measures a company’s current value against how much it actually earns in income. You can calculate it two different ways, by:

- Taking the company’s market cap and dividing it by net income – OR
- Dividing a company’s current stock price by earnings per share

You’ll wind up with the same number either way because in the share price approach, both numbers have already been divided by the total number of shares the company has outstanding. So it’s two different ways to the same place.

Now you’ll usually see the p/e ratio quoted two different ways:
Trailing twelve month (TTM) – which looks at the company’s actual income over the past twelve months.

Forward – This approach takes analyst estimates of earnings expectations for the upcoming year and using that as the earnings figure.
If a company is growing, its forward p/e ratio will always be smaller than its trailing twelve month p/e ratio, because more income is expected and the denominator will be larger.

If you see a p/e ratio out in the wild and it isn’t specified which kind it is, you can probably assume it’s based on the company’s trailing twelve month earnings.

The P/E ratio only works if there’s an E – or earnings.
So it’s a helpful tool for companies that have income, but it’s totally useless if a company isn’t currently profitable. That’s why investors also use another tool

For unprofitable companies, the p/e ratio would return a negative number, which really wouldn’t be very helpful, so instead investors use the price to sales ratio.

This is a company’s market cap divided by its total sales over the past twelve months. High growth software companies can have price-to-sales ratios of over 10, while more established businesses are usually in the mid to low single digits.

The P/E and P/S ratios are great because they allow you to normalize companies of different sizes and immediately get a sense of what investors are willing to pay for a piece of that company's earnings or revenue. You can use these ratios to compare how a company stacks up to the overall stock market, peers in their industry, or itself relative to the past.

Generally, businesses that are posting high growth rates are going to have higher price-to-earnings and price-to-sales ratios. That’s because investors expect that company to be considerably bigger in the future, and they have bid up shares to reflect that.

That doesn’t mean that they’re bad stocks to own, it just means that people are expecting big growth to continue and if it doesn’t, shares could fall dramatically.

Conversely, stodgy old businesses in crawling industries tend to have lower p/e ratios because they aren’t growing very quickly – for them this year’s earnings will probably look a lot like last year’s earnings. The market isn’t expecting much from stocks with low valuations, so if the outlook gets worse, they’re less likely to take a huge hit, but they’re also less likely to give investors huge returns.

By now you’ve probably realized that these aren’t very complicated calculations to do. Valuation sounds scary to new investors, but really all you’re trying to do with these numbers is get a sense of how much you have to pay for a dollar of earnings or revenue from a company, and what the market expects of that company.

There’s one more easy valuation metric you look at to see how a company’s valuation compares to the growth the company is posting.

The PEG ratio takes the value from the company’s PE ratio, and then compares it to the company’s earnings per share growth rate.
So to calculate it, you first find the P/E ratio for a company, then divide it by the year-over-year earnings growth rate.

The generally accepted rule is that a PEG ratio of 1 represents a “fair value” while anything under 1 is cheap and anything over 1 is expensive compared to the growth the company is posted.

For all these ratios there aren’t absolutes, just guidelines. As investors we’re looking for quality companies with good business models and exciting growth prospects -- it’s worth paying a premium for companies like that, these metrics help us understand what the premium looks like and how it fits into the company’s growth story.

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[jasong]

Love this explanation, I feel like I’ve watched all the “P/E explained” videos on youtube and this one is the best!

[perrykeshahwalker]

Greetings guys. I am a new investor. I have a Robin hood account. I have invested in a company called Inpixon. They are supposedly the leaders in indoor GPS tracking systems etc. I caught the video from motley fool that talks about how to value a company. Inpixon has a negative pe rating and a ps of 1.19. Should I dump this stock. I only have 122 share that I purchased for 1.18usd?

[jakechard]

Great video loved it could you please do other videos using DCF valuation and other valuation models to value companies.

[businessguide]

Keep posting interesting contents like this!

[hindenburgminsky]

Thanks for the video. I learnt more in here than attending a finance class at uni.

[trefoboyz]

Music and Film thanks The Motley Fool and potential Investors!

[robertmiller]

Very informative, it makes it easy to understand the different ratios used. Thank you. I hope more Fools Answer Questions come soon.

[InvestingwithKurt]

That was a really nice video - great break down and to the point

[vangvon]

Concise, well-paced and right on point, weeellll done! and thanks!

[alvarocalcedoriveiro]

Great job...
If P/S Ratio is High, but the P/B is Low... what is the interpretation???

[randomactsofkindness]

I am truly sad you have disappeared from this platform... I used to listen to your podcasts so much back when you still posted them... Please come back! 😅

[thomashunt]

Great video for a newby like myself but where do we find this data so we can figure these equations? Thanks!

[ciarangell]

why dont i get the starter kit from the link after i put in my email?

[SergiMedina]

Quite good content, and I don't say that lightly!

[johnobrien]

Please stop paying whoever is hemorrhaging your money on harassing ad campaigns . I have never heard of your company nor have any interest in it yet I have to put up with 9-12 of your ads during my 2-hour workout EVERY SINGLE DAY.

[maf]

Should we pay close attention to George Gilder?

[brandon]

What is a good p/e ratio range for an undervalued company?

[arianna]

What game of 4D chess are you guys playing? Clever.

[douglepong]

Ratios are nice... In theory.. it would be better if everything in the market followed these ratios... They don't.. motley fool is all over the place with advice. These videos are helpful to learn about what analysts look for but their advice on stocks are tergiversating.. one day they'll think the stock is terrible, and the next day they'll think the stock is gold. Than they'll have the audacity to say that they knew it would hit all along. You can construed that it's different writers talking about the same stock but in terms of a company as a whole they contradict themselves a lot, and people end up with really bad stock advice. My advice is to people who are new in being a retail investor is to use your own judgement. A few months ago the Motley fool advised everyone that cgx was a terrible stock to invest in at 9 to 10 dollars a share. I ignored their advice because covid was the main catalyst to why the stock is so low. Later they posted an article to invest in the stock at 11 dollars a share. Now they posted about how volatile the stock is. For so called "professional investors" the Motley fool workers aren't psychic, and usually don't know what they're doing. Just trust yourself, and ask why you're buying shares of this company in the first place.

[brandonbaumann]

You guys give terrible stock advice! If you're trying to figure out how to make money day trading?!?! Use a screener and follow the volumes! Thank my later!