The Basic Ratios for Stock Analysis

Determining the intrinsic value of a stock can be difficult and inconclusive when using different models, but one simple way to value an equity security is using the basic ratios for market multiples. The three following ratios are considered the basic ratios:

Price to Earnings:

The P/E ratio is one of the first ratios all investors look at before they make a decision. It tells investors how much they are paying (price) over the years of earnings (net income per share) they have made or are expecting, which is the difference between twelve trailing months and forward earnings respectfully. This ratio can sometimes be expensive relative to past performance if a company has good growth prospects. If a company looks like net income will decline in the future, the P/E ratio will look cheaper relative to it’s past performance. This can make the ratio powerful in determining the outlook on an asset and whether it is cheap or expensive relative to an asset’s earning power.

Price to Book:

The book value of a company is defined as the total assets minus liabilities.  The Price to Book ratio helps define a margin of safety for investors, as it tells investors what assets they own and what could be available in the case of bankruptcy or liquidation. If a company is trading at a P/B ratio less than 1, it is considered to be traded at a discount, and if the company is trading at a ratio greater than 1, the company is considered to be trading at a premium.

Price to Sales:

The sales, or revenue, can be a good tool for valuation when a company is not generating earnings or is relatively small (which is better for venture capital rather than public stocks). The price to sales ratio indicates how much an investor will be paying for revenue per share. The P/S ratios differ massively between industries, as each industry carries a different level of profitability and revenue only shows the dollar value the company brings in, not the amount that trickles down the income statement as profit.

These three ratios are just the fundamental multiples used to value stocks, but these ratios should not be viewed on their own as an independent reason to invest. These valuation metrics can be skewed for multiple reasons and only by looking at all three ratios, if not more, can you get a complete image of the operations and value of the equity of a company.