Introduction to Stock Valuation
Stock analysis can seem overwhelming, but it boils down to answering one question: "Is this stock worth the current price?"
This guide will teach you the essential metrics and ratios used by professional investors to make informed decisions. Let's start with the basics and build up to advanced techniques.
1. P/E Ratio (Price-to-Earnings)
P/E = Stock Price ÷ Earnings Per Share
What It Means
The P/E ratio tells you how many years of earnings you're paying for when you buy the stock. If a stock has a P/E of 20, you're paying $20 for every $1 of annual earnings.
How to Interpret
- Low P/E (5-15): Potentially undervalued or slow-growing company
- Medium P/E (15-25): Fair value for most established companies
- High P/E (25+): High growth expectations or potentially overvalued
Limitation: P/E doesn't consider growth rate. A high-growth tech stock with P/E of 30 might be a better value than a slow utility with P/E of 15.
2. PEG Ratio (Price/Earnings-to-Growth)
PEG = P/E Ratio ÷ Earnings Growth Rate
What It Means
PEG adjusts the P/E ratio for growth, giving you a fairer comparison between companies with different growth rates.
How to Interpret
- PEG < 1.0: Potentially undervalued (buying growth at a discount)
- PEG = 1.0: Fairly valued (Peter Lynch's "fair value")
- PEG > 1.0: Potentially overvalued (paying a premium for growth)
Advantage: PEG is one of the best single metrics for growth stocks. It levels the playing field between different industries.
3. PEGY Ratio (PEG + Yield)
PEGY = P/E ÷ (Growth Rate + Dividend Yield)
What It Means
PEGY is the ultimate valuation metric for dividend stocks. It considers both growth AND dividend yield, giving you the complete picture of total returns.
When to Use
- Dividend-paying stocks
- REITs and utilities
- Mature blue-chip companies
- Income-focused investing
Example: A stock with 10% growth + 4% dividend yield (14% total) at P/E of 18 has PEGY of 1.29 — much better than the PEG of 1.8.
4. Other Essential Metrics
Market Cap
Formula: Share Price × Shares Outstanding
Shows company size. Large-cap ($10B+) = stable, small-cap ($300M-$2B) = higher growth potential but riskier.
Dividend Yield
Formula: Annual Dividend ÷ Stock Price × 100
Shows income return. 3-5% typical for good dividend stocks. Above 7% may indicate dividend cut risk.
EPS Growth Rate
Annual rate of earnings per share increase
Core input for PEG/PEGY. 15-20% growth excellent. Above 30% may be unsustainable.
Debt-to-Equity
Formula: Total Debt ÷ Shareholder Equity
Shows financial risk. Below 0.5 = conservative, above 2.0 = high debt risk.
Return on Equity (ROE)
Formula: Net Income ÷ Equity × 100
Shows efficiency of capital use. Above 15% good, above 20% excellent.
P/S (Price-to-Sales)
Formula: Market Cap ÷ Total Revenue
For unprofitable companies. Below 2 good for established. Tech/growth 3-10 acceptable.
P/B (Price-to-Book)
Formula: Stock Price ÷ Book Value Per Share
Below 1 = value play. Best for banks, real estate, asset-heavy companies.
Profit Margin
Formula: Net Income ÷ Revenue × 100
Above 10% solid, above 20% excellent. Varies by industry.
Beta (β)
Volatility vs market
Beta < 1 = less volatile. Beta > 1.5 = high volatility. Risk indicator for portfolio.
5. Step-by-Step Stock Analysis
- 1.
Understand the Business
What does the company do? How does it make money? Is it a leader in its industry?
- 2.
Check the Financials
Look at revenue growth, profit margins, and debt levels over the past 3-5 years.
- 3.
Calculate Valuation Metrics
Use our calculator to get P/E, PEG, and PEGY. Compare to industry averages and competitors.
- 4.
Assess Growth Potential
Is the growth rate sustainable? What's the company's competitive advantage? Any threats?
- 5.
Consider Dividends
For income investors: Is the dividend safe? Check payout ratio (<60% is healthy) and dividend history.
- 6.
Make Your Decision
If PEG/PEGY < 1.0, solid business, and manageable debt, likely a good value. Otherwise, keep researching.
Common Beginner Mistakes
1. Relying on One Metric
Don't buy a stock just because it has low P/E. Use multiple metrics and understand the business.
2. Ignoring Industry Context
Tech stocks naturally have higher P/E ratios than utilities. Compare companies within the same sector.
3. Using Unrealistic Growth Rates
Be conservative with growth estimates. If 50% growth seems too good to be true, it probably is.
4. Chasing Dividend Yields
Very high yields (7%+) often signal trouble. Check if the company can afford to maintain the dividend.
5. Forgetting About Debt
A company with attractive ratios but crushing debt is still risky. Always check the balance sheet.
Quick Decision Framework
Key Value Indicators
PEG or PEGY < 1.0
Revenue growing consistently
Debt-to-Equity < 1.0
Strong competitive position
Industry you understand
Meeting most criteria indicates a strong candidate for further research
Additional Resources
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