Equity Valuation Ratios

Investors use several equity valuation ratios to assess whether an individual stock or a stock market index is expensive ("rich") or cheap. The most commonly used ratios are Price-to-Earnings (P/E), Price-to-Sales (P/S), and Price-to-Book Value (P/BV).

Understanding the Price-to-Earnings Ratio

The Price-to-Earnings (P/E) ratio is perhaps the most widely used measure that compares a company's share price to its earnings per share (EPS). This fundamental metric tells us how much investors are willing to pay for each dollar of a company's earnings.

Advanced P/E Variations

There are multiple ways to calculate P/E ratios, each offering different insights:

• Trailing P/E: Based on the past 12 months of earnings
• Forward P/E: Uses projected earnings for the next 12 months
• CAPE Ratio: Cyclically-adjusted P/E introduced by Prof. Robert Shiller, using 10-year average inflation-adjusted earnings to smooth out business cycle fluctuations. Learn more about CAPE

Interpreting P/E Ratios in Context

A high P/E ratio may reflect either that a stock is overvalued, or that the market expects significant future growth. Conversely, a low P/E ratio could indicate an undervalued opportunity or pessimistic growth expectations.

Value investors typically seek undervalued companies with solid fundamentals, while growth investors focus on companies with high earnings growth potential, often in technology or consumer discretionary sectors.

P/E ratios require contextual analysis. Investors should compare:

• Company's current P/E vs. industry peers
• Company's current P/E vs. its historical range
• Growth rates and business quality factors
• Sector-specific characteristics and cycles

The exhibit above illustrates how P/E ratios vary significantly across industries. Microsoft, a technology company with high growth expectations, trades at a premium valuation compared to JP Morgan, a mature financial institution with steady but lower growth prospects.

Predictive Power of Valuation Metrics

While P/E ratios have limitations for individual stock selection, they demonstrate significant predictive power for market-level returns over longer time horizons. The inverse of the P/E ratio (E/P), called the "earnings yield", provides particularly valuable insights.

The analysis reveals a crucial insight: while earnings yield shows little predictive power over 1-year periods, it demonstrates strong correlation with 10-year returns. This suggests that:

• Short-term markets are driven by sentiment, momentum, and technical factors
• Long-term markets are ultimately driven by fundamental valuations
• Mean reversion occurs over extended periods, making valuation a powerful long-term timing tool

Professional Application

Institutional investors and professional analysts use valuation ratios as part of comprehensive frameworks that include:

• Multi-factor models combining valuation, quality, momentum, and size factors
• Sector rotation strategies based on relative valuations across industries
• Risk management using valuation metrics to assess portfolio concentration
• Asset allocation decisions incorporating market-level valuation assessments

For comprehensive valuation analysis including DCF modeling, sector comparisons, and portfolio optimization, explore our suite of professional tools designed for investors and analysts.