Depending on the nature of the investment, we analyze the price-to-earnings (P/E) ratio, price/earnings to growth (PEGs) ratio and price-to-sales (P/S) ratio as well as other key indicators, for both the company and its competitors. We look for any signs of inconsistencies or discrepancies that would require further examination.
P/E ratios help us form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), valuations based on trailing earnings or on current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors. Basic “growth stock” versus “value stock” distinctions can be made here, along with a general sense of how much expectation is built into the company. These snapshots help us assess the potential return on the investment.
Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a critical step.
Finally, the PEG ratio brings into account the expectations for future earnings growth, and how it compares to the current earnings multiple. In some areas this ratio may be less than one, while in others it may be as much as 10 or higher. Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.