Stock Screening Tools: Valuation Ratios - dummies

# Stock Screening Tools: Valuation Ratios

Once you start using stock screening tools, you will likely be hooked. For value investors (who embrace fundamental analysis), the following parameters are important to help home in on the right values.

## Price/Earnings Ratio

The P/E ratio (price-to-earnings ratio) is one of the most widely followed ratios, and many consider it the most important valuation ratio (and it can be considered a profitability ratio as well). It ties the current stock price to the company’s net earnings. The net earnings are the heart and soul of the company, so always check this ratio.

All things being considered, you will likely want low ratios (under 15 is good, under 25 is acceptable). If you’re considering a growth stock, you definitely want a ratio under 40 (unless there are extenuating circumstances that aren’t reflected in the P/E ratio).

Generally, beginning investors should stay away from stocks that have P/Es higher than 40, and definitely stay away if the P/E is in triple digits (or higher), because that’s too pricey. Pricey P/Es can be hazardous, as those stocks have high expectations and are very vulnerable to a sharp correction. In addition, definitely stay away from stocks that either have no P/E ratio or that show a negative P/E. In these instances, it’s a stock where the company is losing money (net losses). A company that’s losing money means that buying the stock is not investing — it’s speculating.

Make sure your search parameters have a minimum P/E of, say, 1 and a maximum of between 15 (for large cap, stable, dividend-paying stocks) and 40 (for growth stocks) so that you have some measure of safety (or sanity!).

If you want to speculate and find stocks to go short on (or buy puts on), two approaches apply:

• You can put in a minimum P/E of, say, 100 and an unlimited maximum (or 9,999 if a number is needed) to get very pricey stocks that are vulnerable to a correction.
• A second approach is putting in a maximum P/E of 0, which would indicate that you’re searching for companies with losses (earnings under zero).

Keep in mind that shorting is risky and is a form of speculating, so the safer and more assured route is investing in stocks tied to quality, profitable companies for the long term.

## Price/Book Ratio

A major valuation is the price-to-book (P/B) ratio. This compares the price of the stock (market capitalization) to the net asset value (or “book” value) of the underlying company. Ideally, the ratio should be 1-to-1, where the market value and the book value are at parity, but you won’t usually find that. Just know that the closer the market value is to the book value, the better the value. A P/B ratio of under 4 is optimal; if it’s higher, it’s getting too pricey.

A market value that’s much higher than the book value may indicate an overvalued stock, so tread carefully here. In the stock screener’s P/B ratio field, consider entering a minimum of 0 but making the maximum 4, because buying a stock whose market capitalization is four times greater than the company’s book value is getting pricey.

## Price/Sales Ratio

In terms of calculation, this ratio is similar to the P/B ratio, but just substitute the book value with the total annual sales. Again, a price-to-sales (P/S) ratio close to 1 is positive. When market capitalization greatly exceeds the sales number, then the stock leans to the pricey side.

In the stock screener’s P/S field, consider entering a minimum of 0 or leave it blank. A good maximum value would be 3.

## PEG Ratio

You obtain the PEG (price-to-earnings growth) ratio when you divide the stock’s P/E ratio by its year-over-year earnings growth rate. Typically, the lower the PEG, the better the value of the stock. A PEG ratio over 1.00 suggests that the stock is overvalued, and a ratio under 1.00 is considered undervalued. Therefore, when you use the PEG ratio in a stock screening tool, leave the minimum blank (or 0), and use a maximum of 1.00.

## Other valuation ratios

Some stock screeners may include other ratios. One good one is the average five-year ROI (return on investment), which gives you a good idea of the stock’s long-term financial strength. Others may have an average three-year ROI.

Because this is an average (percentage terms) over five years, do a search for a minimum of 10 percent and an unlimited maximum (or just plug in 999 percent).