Price-to-earnings (P/E)
The price-to-earnings ratio divides a stock's price by its earnings per share. A P/E of 20 means investors are paying $20 for every $1 of annual earnings. Higher P/E implies investors expect faster future growth; lower P/E implies slower growth or higher risk.
P/E is the most widely used valuation metric but also the most widely misunderstood. A high P/E alone doesn't mean a stock is expensive — it depends on the growth rate. A company growing earnings at 30% per year with a P/E of 40 may be cheaper than a company with flat earnings at a P/E of 15.
The PEG ratio (P/E divided by earnings growth rate) normalizes for growth. A PEG below 1 typically indicates undervaluation relative to growth. The forward P/E (using next-year estimated earnings rather than trailing) is more useful for growth stocks because it reflects where earnings are going, not where they've been.
Valuation metrics are most useful in comparison: to the stock's own history, to sector peers, and to the broader index. A P/E of 25 might be cheap for a high-quality compounder but expensive for a cyclical business at peak earnings.
Price-to-sales (P/S) and other metrics
For companies with negative earnings (high-growth tech, biotech, early-stage businesses), P/E is undefined. Price-to-sales divides market cap by annual revenue and provides a valuation anchor even for unprofitable companies. A P/S of 5 means investors pay $5 for every $1 of annual revenue.
Enterprise Value to EBITDA (EV/EBITDA) is preferred by analysts because it's capital structure neutral — it compares what you'd pay for the entire business (including debt) against operating cash generation before financing costs and non-cash charges. It's better for comparing companies with different debt levels.
Price-to-book (P/B) compares price to accounting net worth. It's most relevant for financial companies (banks, insurance), real estate, and value stocks. A P/B below 1 means you're paying less than the liquidation value of the assets — unusual and often a value signal.
Discounted cash flow (DCF)
A DCF model values a company by projecting its future free cash flows and discounting them back to present value using a required rate of return. It's theoretically the most rigorous valuation method because it's directly connected to the economic value of owning a business.
DCF is highly sensitive to assumptions. Small changes in the discount rate or terminal growth rate cause large swings in the resulting valuation. A company valued at $100 with a 10% discount rate might be valued at $70 with a 12% rate — which is why rising interest rates are particularly destructive to growth stock valuations.
Use DCF to establish a range of reasonable intrinsic values under different assumptions, not a precise number. If a stock trades at a 40% discount to even your bear-case DCF, that's a strong value signal. If it requires extremely optimistic assumptions to justify the current price, the margin of safety is thin.