There are a number of widely used financial ratios that can be used to help investors gauge valuation and assess how a company stacks up against its peers. These ratios are standard on broker platforms as well as most popular search engines. Just as with technical analysis, financial analysis should be performed using multiple financial ratios to help paint a clearer picture of the operations.
Price-Earnings (P/E) is perhaps the most commonly used financial ratio. It measures the profitability of the company relative to the share price. All sectors have an average P/E, which can be found quickly by looking up the heaviest traded exchange-traded-funds (ETF) which track the specific index. This ratio can be used to compare a specific company with the industry, peers and or benchmark indices. For example, if the consumer discretionary sector has a P/E of 20 and your stock has a P/E of 55, it may be overvalued. Some sectors traditionally have higher P/Es than others, like technology compared to utilities. The S&P 500 has a historical P/E ratio of 21. Keep in mind that a company needs to generate profits in order to have a P/E. There are more ratios that can be used in the absence of profits.
Price-Sales (P/S) and Price-Book (P/B) are comparative valuation ratios that indicate if a stock is trading at a premium or discount compared to its peers and sector/industry. If a stock is trading at a very deep discount like .3 P/S compared to industry average of 2.5 P/S, then there could be an inherent structural problem with the business or could be overlooked by Wall Street and presents an undervalued investment situation and warrants further investigation.
Cash-Per-Share (CPS) and Book Value (BV) are two valuation ratios that can help determine if the stock has been overly punished by investors. When a company trades under the CPS or BV, it has virtually valued the business operations at zero presenting either a very undervalued situation or potential bankruptcy. The cash burn rate and debt should also be investigated. Biotech stocks are notorious for these situations. These ratios don’t apply well to financials like banks and insurance companies that tend to trade at or below CPS and BV, due to federal banking regulations and off balance sheet entities.