Key Valuation Ratios

Introduction

The P/E ratio is the headline act of valuation, but it is one instrument in a larger orchestra — and it falls silent precisely when you need it most: for companies with no profits, with heavy debt, or with value that lies in assets rather than earnings. A capable analyst carries a toolkit of valuation ratios, each illuminating a different facet of a company's price relative to some measure of its substance — its assets, its sales, its cash earnings, its dividends, its growth. No single ratio is sufficient; together they triangulate toward a judgement about whether a stock is cheap or dear, and they cross-check one another's blind spots.

This lesson builds on the P/E and balance-sheet lessons. It tours the most important multiples beyond the P/E — price-to-book, price-to-sales, EV/EBITDA, the PEG ratio and dividend yield — explaining what each measures, the situations where it shines, and where it can mislead.

Quick Definition

A valuation ratio compares a company's market price (or value) to some fundamental measure of its substance — earnings, assets, sales, cash flow or dividends — producing a number you can compare across companies and over time. Each ratio answers "how much am I paying for this aspect of the business?"

The common thread is price relative to something real. A raw share price means nothing; a price relative to earnings, or book value, or sales, becomes a comparable gauge of value. The art is choosing the right denominator for the company in front of you.

Price-to-Book (P/B)

The price-to-book ratio compares the share price to the company's book value per share — the accounting net worth (equity) from the balance sheet, divided by the share count.

P/B = Share price ÷ Book value per share.

A P/B of 1 means you are paying exactly the accounting value of the company's net assets; below 1, you are paying less than book value (potentially a bargain, or a warning the assets are impaired); above 1, a premium for the business beyond its assets. P/B shines for asset-heavy companies — banks, insurers, property firms, investment trusts — whose value lies largely in tangible assets carried on the balance sheet. It is far less useful for asset-light businesses — software, consultancies, brands — whose real value (people, intellectual property, network effects) barely appears in book value, so their P/B can look absurdly high while the company is perfectly reasonably priced.

Price-to-Sales (P/S)

The price-to-sales ratio compares the price to the company's revenue per share.

P/S = Share price ÷ Sales per share (equivalently, market cap ÷ total revenue).

Its great virtue is that revenue is positive even when profits are not. For an early-stage, fast-growing, or temporarily loss-making company — where the P/E is meaningless — P/S provides a valuation anchor against the one thing the business reliably produces: sales. Its weakness is the mirror image: it says nothing about profitability. Two companies with the same P/S can be worlds apart if one converts sales into fat profits and the other into losses. P/S is best used for revenue-rich, profit-poor situations, and always alongside a profitability check — a low P/S on a business that never makes money is no bargain.

EV/EBITDA

A more sophisticated cousin of the P/E, EV/EBITDA fixes two of the P/E's blind spots: debt and financing.

• Enterprise value (EV) is the market capitalisation plus net debt — the cost to buy the entire business, including taking on its debts. This matters because two companies with the same market cap but different debt loads are not equally priced; EV captures the true cost.
• EBITDA is earnings before interest, tax, depreciation and amortisation — a measure of operating cash earnings stripped of financing and accounting choices.

EV/EBITDA = Enterprise value ÷ EBITDA.

Because it includes debt (via EV) and removes the distortions of different tax and financing structures (via EBITDA), EV/EBITDA allows a more like-for-like comparison between companies — especially those with very different debt levels, which the P/E can flatter or punish. It is a favourite for comparing companies within capital-intensive industries and is widely used in takeover analysis. Its caveat: by ignoring the real costs of debt interest, tax and the capital needed to replace depreciating assets, EBITDA can paint a rosier picture than free cash flow — never mistake it for the cash a business actually keeps.

The PEG Ratio

The P/E lesson stressed that a high P/E can be justified by growth. The PEG ratio makes that explicit by dividing the P/E by the expected earnings growth rate:

PEG = P/E ÷ Annual earnings growth rate (%).

The idea is elegant. A P/E of 30 looks expensive in isolation — but if the company is growing earnings at 30% a year, its PEG is 30 ÷ 30 = 1.0, often considered fair value, because you are paying for growth that is actually arriving. A P/E of 30 on a company growing at 5% gives a PEG of 6 — genuinely expensive. By placing the multiple in the context of growth, PEG helps compare fast growers and slow growers on a fairer footing, and is a staple of growth-investing analysis. Its weakness is its reliance on a forecast growth rate, which is uncertain and easily too optimistic — a low PEG built on fantasy growth is a mirage.

Dividend Yield

For income-focused investors, the dividend yield is the headline number. It expresses the annual dividend as a percentage of the share price:

Dividend yield = Annual dividend per share ÷ Share price.

A £2 annual dividend on a £50 share is a 4% yield. It tells an income investor what cash return the shares pay today, comparable to a savings rate or bond yield. But two cautions, both echoing earlier lessons. First, a very high yield is often a warning, not a gift: it usually means the share price has collapsed because the market expects the dividend to be cut — a yield trap. Second, yield says nothing about whether the dividend is sustainable; always check (via the payout ratio and the cash flow statement) that earnings and free cash flow comfortably cover the payout. A 7% yield that is about to be halved is worth far less than a secure, growing 3%.

Choosing The Right Ratio

The crucial skill is matching the ratio to the company, because each suits different situations:

The deeper principle is relative valuation. A ratio in isolation means little; its power comes from comparison — a company against its own history, its direct competitors, and its industry average. And crucially, use ratios together. A stock that looks cheap on P/E, P/B and EV/EBITDA, with a secure dividend, is a more convincing bargain than one cheap on a single measure that might be distorted. When the ratios disagree, that disagreement is itself a signal — it tells you which measure is being flattered or punished, and points you toward the question worth asking.

Common Misconceptions

• "One ratio can value any company." Each suits different businesses — P/E for steady earners, P/B for asset-heavy firms, P/S for unprofitable growers. The wrong ratio for the company misleads.
• "A low ratio always means cheap." Low P/E, P/B or P/S can all be traps — cheap because the market correctly expects decline. Always ask why it's low.
• "EBITDA is the cash a company makes." EBITDA ignores interest, tax and the capital needed to replace assets. It is a comparison tool, not free cash flow — don't confuse the two.
• "A high dividend yield is always good." An unusually high yield often signals an impending dividend cut. Check the payout is covered by earnings and cash before trusting it.

Real-World Application

An investor is comparing three companies and wisely refuses to judge them all by the P/E. The first is a profitable, steady consumer brand — the P/E and PEG do the job, showing a reasonable price for modest, reliable growth. The second is a bank, where the P/E is noisy but the P/B is illuminating: it trades below book value, cheap relative to its peers and its own history, worth a closer look at why. The third is a fast-growing but still loss-making software firm, where the P/E doesn't exist at all; here P/S, judged against similar growth companies, provides the only sensible anchor, cross-checked against its path to profitability. For each, the investor reached for the right tool — and where they had earnings, they looked across several ratios at once, treating disagreement between them as a prompt to dig deeper. That discipline — matching the measure to the company, comparing relative to peers, and never trusting a lone multiple — is what turns a drawer full of ratios into actual judgement.

Key Takeaways

• Valuation ratios compare price to a measure of substance — earnings, assets, sales, cash earnings or dividends — and each suits different companies.
• P/B (price ÷ book value) suits asset-heavy firms like banks; P/S (price ÷ sales) suits unprofitable growers where the P/E breaks down but ignores profitability.
• EV/EBITDA includes debt (via enterprise value) and strips out financing and tax, giving a more like-for-like comparison across companies — but EBITDA is not free cash flow.
• PEG (P/E ÷ growth) puts a high P/E in the context of growth; dividend yield (dividend ÷ price) is the income investor's gauge — but a very high yield often warns of a coming cut.
• No ratio is enough alone: use relative valuation (versus peers, industry and history) and several ratios together, treating disagreement between them as a signal to investigate.