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Valuation Ratios Provide Insight into Stock Investment Value

Determining whether a stock is cheap or overvalued is an arduous process for online investors. Gaining insight into how pricey a stock is can be a full-time job, even for investment pros. Luckily, valuation ratios provide a quick way for you to get an idea of how pricey a stock is.

Most financial Web sites that provide stock quotes also provide several valuation ratios. Reuters, for example, provides you with nearly all the important valuation measures on one screen. Just enter the stock symbol in the Enter Stock Symbol text field, select the Financial radio button, and then click the Search button. If you scroll down, you find more ratios than you can shake a stick at.

Here is a list of a few valuation ratios you should pay the most attention to.

  • Price-to-earnings (P/E): This is measured by the dividing stock price by the company’s annual earnings. A high P/E ratio tells some investors that the stock is overvalued, and a low P/E ratio shows it’s undervalued.

  • Price-to-sales: This ratio is typically used to value early-stage companies, like biotech firms, that lose money, so they don’t have a P/E ratio.

  • Price-to-book value: This value ratio is the stock’s price divided by the company’s book value per share. A company’s book value measures the value of what it owns (assets) minus what it owes (liabilities). The price-to-book value ratio is very important and is a key measure used to determine whether a stock is a value-priced stock or a growth stock. A low value ratio, typically 1 or lower, might signal an undervalued stock.

  • Price-to-tangible book value: This is the stock price divided by the company’s book value per share, excluding assets you can’t touch or feel.

  • Price-earnings-to-growth: This ratio compares a company’s P/E ratio to its expected growth rate. The PEG ratio is calculated by dividing the stock’s P/E ratio by its expected growth rate. The expected growth rate is forecasted by analysts who follow the company. A PEG ratio of 2 or higher tells investors that the stock is either expected to grow very rapidly or that the stock is overvalued. Reuters doesn’t give you the PEG ratio, but it gives you the P/E ratio and the growth rate, so you can easily figure it out.

  • Price-to-free cash flow: Here the stock price is divided by free cash flow.

  • Dividend yield: The dividend yield is the company’s annual dividend payment divided by the stock price. If a $30 stock has a dividend yield of 5 percent, that means it is paying $1.50 per share every year in dividends. Stocks with high dividend yields are seen as potentially being undervalued.

The P/E ratio is the rock star of valuation ratios and gets most of the attention. The P/E ratio is popular because it’s easy to understand. Imagine a stock price is $30 a share, and the company earned $1.50 a share. That means investors are paying a price that’s 20 times higher than the company’s earnings. If the price of earnings, or P/E, is high, it means that the earnings are very valuable to other people, usually because they expect the company to grow rapidly.

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