Module 10 · Lesson 3 of 12 · Fundamentals and macro · About 5 minutes
Valuation Ratios Explained: P/E, EV/EBITDA, P/S and Yield
On this page
Before you read: Earnings Reports and Guidance: Estimates, Surprises and Calls
What you will learn
- How the price-to-earnings ratio and its forward version are calculated.
- What enterprise value adds, and how EV/EBITDA and price-to-sales work.
- Why a “cheap” or “expensive” ratio needs context before it means anything.
What is a valuation ratio?
How could you compare the price of a $20 stock with the price of a $400 stock?
A valuation ratio compares a company’s market price with something the business produces or owns, such as earnings, sales, cash flow or book value. The ratio turns the price into a multiple of that measure, which makes companies of different sizes comparable.
How does the P/E ratio work?
How many years of today’s earnings are you paying for?
The price-to-earnings ratio is the share price divided by earnings per share:
- Trailing P/E uses EPS from the last 12 months. A $50 stock with $2.50 of trailing EPS has a P/E of 20.
- Forward P/E uses estimated EPS for the next 12 months or fiscal year. If estimates are $3.125, the forward P/E is 16.
The inverse, EPS divided by price, is the earnings yield. A P/E of 20 is a 5% earnings yield. P/E is meaningless when earnings are negative, and it moves when one-off items change earnings. Some investors divide P/E by expected earnings growth (the PEG ratio) to account for growth, which adds a forecast to the calculation.
What is enterprise value?
If you bought the whole company, would you also take on its debt?
Enterprise value (EV) estimates the value of the whole business, not only the shares:
EV = market capitalization + debt − cash (with adjustments for items such as preferred stock and minority interests).
EV is often compared with EBITDA, which is earnings before interest, taxes, depreciation and amortization. Because EV includes debt and EBITDA comes before interest, EV/EBITDA compares companies with different amounts of borrowing more fairly than P/E does. EBITDA is not a cash measure and leaves out the cost of replacing equipment, so it flatters capital-heavy businesses.
Example. A fictional company has a market capitalization of $8 billion, $3 billion of debt and $1 billion of cash. EV is $10 billion. With EBITDA of $1 billion, EV/EBITDA is 10.
Valuation diagram
Illustrative diagram constructed for teaching. Not real market data.
The diagram compares two fictional companies with the same market capitalization. One carries large debt, the other large cash, so their P/E ratios look similar while their enterprise values and EV/EBITDA ratios differ. It is constructed for teaching and is not real market data.
Try it on a chart
- Find Microsoft's price-to-earnings ratio and its enterprise value.
- Find the price-to-sales ratio and compare it with the P/E.
Charts and quotes are TradingView's data, not ours, and may be delayed.
What about sales, book value and dividends?
What can you compare when a company has no profit yet?
- Price-to-sales (P/S) compares market capitalization with revenue. It works for companies without profits, but ignores costs; a business with thin margins can look cheap on sales.
- Price-to-book (P/B) compares market capitalization with shareholders’ equity. It is used more for banks and insurers, whose assets are mostly financial.
- Dividend yield is the annual dividend divided by the price, covered in the corporate actions lesson.
- Free cash flow yield compares free cash flow with market capitalization.
Why does context matter?
A ratio of 30 is high compared with what?
A ratio on its own is just a number. Readers usually compare it with:
- the company’s own history;
- similar companies in the same industry;
- the wider market;
- expected growth and interest rates. When rates are higher, investors often accept lower multiples, other things equal.
A low ratio can mean a business is out of favor or that earnings are about to fall. A high ratio can mean high expected growth or optimism that may not last. Ratios describe the price relative to a measure; they do not say whether that price is right.
What this does not tell you about valuation
- Whether any stock is cheap, expensive or worth buying.
- Which ratio is best. Each leaves something out.
- That data sites calculate ratios the same way. Definitions of earnings, debt and EBITDA differ.
- Nothing here recommends any stock or valuation approach.
Check yourself
- A stock trades at $60 with trailing EPS of $3. What is the trailing P/E? Hint: price ÷ EPS.
- Market capitalization $5 billion, debt $2 billion, cash $500 million. What is EV? Hint: add debt, subtract cash.
- Why can a company with a low P/E still be a poor business? Hint: what if earnings are about to fall?
Reflect on your own process
- When you note a valuation ratio, do you record whether it is trailing or forward and which data source calculated it?
- What comparison does your process require before you call a ratio high or low: the company's history, peers or the market?
- How would you check a data site's EV or EBITDA figure against the company's own filing?