Every day, we hear things like tech stocks are too expensive or big companies are now cheaper than ever. But how do people really decide if a stock is too expensive or a good deal? That’s where valuation ratios come in.

These ratios help investors figure out how much they should pay for a company’s earnings or sales by comparing them to other similar companies. This way of investing is called value investing. It’s the opposite of growth investing, where people buy stocks expecting them to grow fast.

How to Compare Companies Using Valuation Ratios

Before you use any ratio, you need to find other companies that are similar. You also have to make sure the numbers are clean and not messed up by unusual situations. This helps you compare fairly. It’s like comparing apples to apples.

There are many valuation ratios. But here are five of the most important ones that investors use.

Price-to-Earnings Ratio (P/E)

One of the most common ones is the price-to-earnings ratio, or P/E. This simply compares the stock price to the company’s earnings. A low P/E ratio might suggest that a stock is undervalued. It’s easy to calculate and use, but there’s a catch. Earnings can sometimes be adjusted or manipulated with accounting tricks.

Also, this ratio doesn’t consider how fast the company is growing or how much debt it has. So while it’s a helpful starting point, it shouldn’t be the only thing you look at.

Price-to-Book Ratio (P/B)

The price-to-book ratio, or P/B, compares a stock’s price to its book value, which is the company’s net worth on paper. This ratio is more stable and doesn’t change as much over time. It’s especially useful for banks and companies that might not have steady profits.

However, different companies calculate book value differently, especially if they have unusual debt or assets, so it’s not always an apples-to-apples comparison.

Price-to-Cash-Flow Ratio (P/CF)

Then there’s the price-to-cash-flow ratio, which focuses on how much real cash the company is bringing in. This is important because cash is harder to manipulate than earnings.

Investors like this ratio when they’re looking at companies that may not be profitable but are still generating steady cash. The downside is that future cash flow is tough to predict, and it can look very different depending on the business.

Price-to-Sales Ratio (P/S)

Another popular ratio is price-to-sales, or P/S. This one is often used for new companies or IPOs that don’t have earnings yet. It compares the stock price to the company’s revenue. Revenue is more stable and harder to fake than profit, which makes this ratio useful.

However, it doesn’t tell you anything about whether the company is making money from those sales, so it leaves out an important part of the picture.

EV-to-EBITDA

Lastly, we have EV-to-EBITDA. EV stands for enterprise value, which includes the stock price, debt, and subtracts any cash. EBITDA is a measure of earnings before a bunch of financial costs. This ratio gives a fuller view of how expensive or cheap a company really is.

It’s useful for companies in capital-heavy industries like airlines, where regular ratios might hide too much. But this one takes more effort to calculate and understand.

To Conclude

Valuation ratios are great tools to help you figure out if a stock is a good deal or not. But none of them work perfectly on their own. It’s always better to use them together and look deeper into the numbers.

Sometimes a stock may look cheap at first glance, but when you look closely, there may be reasons behind that low price, like heavy debt or low profit margins.

That’s why good investors always combine these ratios with common sense and a closer look at the company’s business.