Using Ratios to Determine If a Stock Is Overvalued or Undervalued (2024)

For investors in the equity markets, determining a stock's intrinsic value is important in trying to determine whether it is overvalued or undervalued.Intrinsic valueis the calculated value of a company using fundamental analysis, which takes into account a variety of quantitative factors. The intrinsic value is usually different than the current market value.

While intrinsic value is often relied on as a base case, many investors and analysts often use a variety of ratios for providing a quicker and easier estimation of a stock’s price. Ratio analysis is also often viewed in conjunction with intrinsic value calculations.

Ratios and Sectors

In general, the use of ratios is often studied within a particular sector. Stock ratio analysis can provide a quick look at the reasonability of a stock’s price, as well as its likelihood of being overvalued or undervalued.

Analysts can also use ratios in fundamental intrinsic value models. Particularly, ratio multiples are used for identifying terminal value calculations as well as creating valuations when free cash flow, operating income, and net income are unreliable or nonexistent.

Comprehensively, there are 100s of ratios that investors can study or use in different types of analysis. Investopedia discusses stock ratio analysis from a multitude of different angles across its website platform.

Below are a few popular ratios that can provide some quick insight into a stock’s price.

P/E Ratio

The price-to-earnings ratio (P/E) can have multiple uses. By definition, it is the price a company’s shares trade at divided by its earnings per share (EPS) for the past twelve months. The trailing P/E is based on historical results, while forward P/E is based on forecasted estimates. In general, P/E is often classified as a type of valuation ratio.

Given a company’s historical earnings per share results, it could be easy for an investor to find an estimated price per share of a stock using the average of P/Es from some comparable companies. Moreover, viewing an actual P/E of a company can also provide insight into the reasonability of the stock when compared to its peers.

The higher the P/E the more speculation is priced into the value, usually from bullish expectations of future potential. This means investors in the public market are willing to pay more per dollar for every $1 of earnings the company produces. Lower P/E’s are usually more reasonable but can also indicate potential undervaluation if considerably lower than peers.

PEG Ratio

The price-to-earnings growth ratio (PEG) is an extended analysis of P/E. A stock's PEG ratiois the stock's P/E ratio divided by the growth rate of its earnings. It is an important piece of data to many in the financial industry as it takes a company's earnings growth into account, and tends to provide investors with a big picture view of profitability growth compared to the P/E ratio.

While a low P/E ratio may make a stock look like it's worth buying, factoring in the growth rate may tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The degree to which a PEG ratio value indicates an over or underpriced stock varies by industry and by company type. Also, a PEG ratio below one is typically thought to indicate that a stock may be underpriced, but this can vary by industry.

The accuracy of the PEG ratio depends on the accuracy and reliability of the inputs. Moreover, the PEG can be calculated with both trailing and forward growth rates. Depending on the analysis, trailing and forward may differ substantially, which will influence the PEG.

Price-to-Book

The price to book (P/B) is another ratio that incorporates a company’s share price into the equation. The price to book is calculated by share price divided by book value per share. In this ratio, book value per share is equal to a company’s shareholder’s equity per share, with shareholders’ equity serving as a quick report of book value.

Similar to P/E, the higher the P/B, the more inflated a stock’s price is. Vice versa, the lower the P/B the greater the potential for upside. Both P/E and P/B are often best viewed in comparison to the ratios of their peers. P/B is often considered a type of solvency ratio.

Price-to-Dividend

The price-to-dividend ratio (P/D) is primarily used for analyzingdividend stocks. This ratio indicates how much investors are willing to pay for every $1 in dividend payments the company pays out over twelve months. This ratio is most useful in comparing a stock's value against itself over time or against other dividend-paying stocks.

Alternative Methods Using Ratios

Some companies don’t have operating income, net income, or free cash flow. They also may not expect to generate any of these metrics far into the future. This can be likely for private companies, companies recently listing initial public offerings, and companies that may be in distress. As such, certain ratios are considered to be more comprehensive than others and therefore better for use in alternative valuation methods.

Price-to-Sales

The price-to-sales (P/S) ratio is often popular because most companies do have sales. These sales will also show some type of growth rate.

The P/S ratio is figured by dividing the current stock price by the12-month sales per share. The current stock price can be found by plugging the stock symbol into any major finance website. The sales per share metric is calculated by dividing a company’s 12-month sales by the number ofoutstanding shares. A low P/S ratio in comparison to peers could suggest some undervaluation. A high P/S ratio would suggest overvaluation.

Enterprise Value-to-Sales

Some companies may not be publicly traded. In this case, there is no public share price or public shares outstanding. Thus, using enterprise value can be helpful.

Enterprise value is an alternative to market capitalization. The main difference is that it factors debt into the equation. For a non-public company, calculate enterprise value-to-sales (EV/S) by adding the shareholders’ equity and total debt then subtracting cash. For a public company, enterprise value can be calculated by simply using the market cap plus the total debt and subtracting cash. Comprehensively, enterprise value is a view of the company’s capitalization.

EV-to-EBITDA

EV-to-EBITDA is similar to EV/S. However, EV/EBITDA requires a company to have a reasonable level of operating income combined with depreciation and amortization. Enterprise value is calculated in the same way as above. EBITDA is calculated by adding depreciation and amortization to operating income (also known as EBIT). EV/EBITDA and other EBITDA multiples are commonly used in merger and acquisition analysis.