How is a stock valued?

Financial ratios are useful metrics for analysing a stock investment. They give investors an indication of a company’s financial performance relative to the overall market, and can be calculated using data extracted from financial statements. 

However, no single ratio alone should be used to value a stock.

Investors usually analyse different ratios to form a more holistic picture of a company's financial health and investment viability.

What are some examples of financial ratios?

The Price-to-Earnings (P/E) ratio and the Price-to-Book (P/B) ratio are two commonly used financial ratios for stock valuation.

The P/E ratio is derived from dividing a company’s current stock price by its earnings per share (EPS). It’s a measure of how much investors are paying for every $1 of a company’s earnings.

In essence, it tells us how the public feels about a company (its stock price) and how well the company is actually doing (its EPS).

A high P/E ratio could mean that either investors expect future earnings to grow and are willing to pay a premium for the stock (e.g. technology companies), or the stock is overvalued. A low P/E ratio could suggest limited growth potential (e.g. utility companies) or that the stock is undervalued.

The P/B ratio is derived from dividing a company’s stock price by its book value (i.e. assets minus liabilities on the balance sheet). In other words, if the company liquidated all its assets and paid off all its debt, the value remaining would be its book value.

A P/B ratio of 1 means that the stock price is trading at fair value, in line with the book value of the company.

P/B is useful mostly for evaluating businesses with tangible assets, such as banks, transportation companies, or manufacturers.

Using these ratios to compare a stock’s performance across peers, time

In general, such financial ratios can vary significantly across sectors and over time, which is why you would want to compare them with the company’s industry averages, as well as their historical and future expected ratios to form a basis of evaluation. 

For a time comparison, analysts look at both the trailing and forward ratios. The trailing ratio is calculated based on the earnings per share in the last 12 months — this is the industry standard for calculating P/E ratios. The forward ratio is based on projections of the company’s earnings over the next 12 months.

As an example, Amazon’s trailing 12-month P/E ratio was 43.74, whereas the average for the internet commerce industry stood at 25.24. This signals that Amazon’s stock could be overvalued when benchmarked against companies that the analysts considered to be similar. 

In terms of future expectations of stock performance, Amazon’s forward P/E ratio was 211.63, far higher than its trailing 12-month P/E. This was largely due to the recent earnings underperformance in Q1 2022, which led analysts to reduce the expected earnings per share, which forms the denominator in the P/E ratio. This reflected those analysts’ bearish views on the stock at the time of writing, which might lead to an investor either choosing not to invest in Amazon or selling the stock.

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