With tariffs and trade wars and AI trouble in the tech space, the S&P 500 is down almost 10% so far this year (to 23 April). Global stock markets have also experienced heightened volatility. For some this is a time to panic. For others, a bargain buying opportunity.
When stock markets take a heavy tumble, more companies’ shares start to look cheaper, in so much as their price is lower than, say, a month ago. But comparing the share price alone is not the best way to determine a stock’s value.
With so many things outside of investors’ control, the one thing they can decide is how much they want to pay for an asset. When looking at the top stocks to buy, a few simple calculations can help you work out if a stock is expensive, just cheap, or really is good value.
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Matt Britzman, senior equity analyst at wealth manager Hargreaves Lansdown, says: “Understanding whether a stock is fairly priced can seem like a daunting task, but it doesn’t have to be.
“By using a few simple valuation tools, you can gain a clearer picture of a company’s worth relative to its performance and the broader market.”
Here are three key measures Britzman says every stock investor should know – price-to-earnings (PE) ratio, price-to-earnings growth (PEG) ratio, and price-to-book (PB) ratio.
1. Price-to-earnings ratio
The P/E ratio is one of the most widely used tools to evaluate a company’s share price compared to its earnings. It tells you how much investors are willing to pay for every £1 of a company’s profit. We explain what is a P/E ratio in a separate article.
The P/E ratio can help you find out if a stock is undervalued or overvalued. You can also use a company’s P/E ratio to compare the price of its stock to those of other companies, for example in the same industry.
A lower P/E means a cheaper share – but cheap does not always represent good value, and can mean there are concerns about the company’s earnings. On the other hand, companies with high P/E ratios might look expensive. But this might point to forecasts of strong, growing earnings.
How is the P/E ratio calculated?
PE ratio = share price / earnings per share (EPS)
For example, if a company’s share price is £20 and it earned £2 per share in the last year, the PE ratio would be:
PE ratio = 20 / 2 = 10
This means investors are paying £10 for every £1 of earnings.
Why does the P/E ratio matter?
- A lower P/E might suggest a stock is undervalued or that its growth prospects are limited.
- A higher P/E can indicate the stock is expensive, investors expect strong growth in the future, or that earnings are high quality.
For example, if the average P/E for similar companies is 15 and your chosen stock trades at 10, it could mean the stock is undervalued, though you’ll want to investigate why.
Hargreaves Lansdown prefers to use an adapted version that uses expected earnings instead of past earnings, known as the forward P/E ratio.
2. Price-to-earnings growth ratio
The PEG ratio takes the P/E ratio one step further by factoring in a company’s expected growth rate. While a stock might look expensive based on its P/E, its growth prospects can sometimes justify the higher price.
How is it calculated?
PEG ratio = PE ratio / earnings growth
For example, if a company has a PE ratio of 20 but is expected to grow its earnings by 10% annually, its PEG ratio would be:
PEG ratio = 20 / 10 = 2
Why does it matter?
- A PEG ratio below one is generally seen as good value, suggesting the stock is good value relative to its growth.
- A PEG ratio above one means the stock might be overvalued relative to its growth rate.
The PEG ratio is particularly useful for growth stocks, where higher PE ratios are common. For instance, technology companies often trade at high PE levels, but their rapid growth can make them attractive investments when the PEG ratio is reasonable.
3. Price-to-book ratio
The PB ratio is another key measure that compares a company’s market value to its ‘book value’, which is essentially the net worth of its assets after liabilities.
You’ll be able to find the book value number on the balance sheet in a company’s annual report. It will be called equity, shareholders’ funds, or net asset value (NAV).
When you know the book value, you can divide the share price by the book value per share, for an idea of how cheap or expensive the company is. If the number you get (the P/B ratio) is less than one that means the company can be bought for less than its assets are worth, making it cheap.
We delve deeper into the details in our article: what is price/book ratio.
How is it calculated?
PB ratio = share price / book value per share
For example, if a company’s book value per share is £10 and the share trades at £15, the PB ratio would be:
PB ratio = 15 / 10 = 1.5
Why does it matter?
- A PB ratio below one could indicate the stock is undervalued, or that investors are wary about its prospects.
- A higher PB ratio could reflect strong market confidence in the company’s future growth.
The PB ratio is particularly useful for industries like banking and manufacturing, where cash and physical assets like property and equipment play a major role. However, for companies with intangible assets – like technology companies – it might be less relevant.
How to put it all together
These three measures, PE, PEG, and PB are great tools for investors because they help simplify complex financial data. By comparing these ratios across similar companies or sectors, you can identify whether a stock offers value, growth potential, or stability.
- Start with the PE ratio for a quick sense of value.
- Use the PEG ratio to account for growth prospects.
- Check the PB ratio for asset heavy businesses.
Remember, no single measure tells the full story, it’s important to compare with:
- The company’s historical ratios to see how its valuation has changed over time, (Hargreaves Lansdown uses a 10-year average). You can find past financial information about a company in its accounts. For large, publicly listed companies these will often be on their website. For smaller UK companies, for example, try Companies House.
- The average valuation of competitors or the market as a whole.
Britzman says: “Investing is for the long term – that’s at least five years. You should also always consider these ratios alongside other factors like the company’s overall financial health, industry trends, and broader economic conditions.
“By combining these tools, you’ll be better equipped to make more informed, confident investment decisions.”
Remember – don’t panic!
When markets are falling, it is essential not to be guided by emotion. The history of the stock market is punctuated by upheavals – corrections are part of the normal investment process.
John Plassard, senior investment specialist at Mirabaud Group, points out: “Historically, the US stock market has suffered a correction of 5% or more almost every year (94%), and double-digit declines are also fairly common.”
The S&P 500 has historically, he adds, averaged a 10% annual return since 1928, despite experiencing an average intra-year drawdown of 16%.
In almost 60% of the years since 1928, the S&P 500 has ended the year with double-digit gains, but in almost half of those years there has also been a double-digit correction along the way.
“This historical context highlights the volatility inherent in the stock market and reminds us that downturns are part of the journey towards long-term growth,” Plassard says.
