7 Key Financial Ratios for Stock Analysis: From P/E to ROE

Introduction

Financial ratios condense company financial statements into compact, comparable metrics investors can use to evaluate valuation, profitability, leverage, liquidity, and growth expectations. For intermediate investors, knowing which ratios matter and how to interpret them by industry is essential for building conviction.

This guide explains seven key ratios: Price-to-Earnings (P/E), Return on Equity (ROE), Debt-to-Equity, Profit Margins (gross, operating, net), Price-to-Book (P/B), Current Ratio, and PEG. You’ll get formulas, practical interpretation tips, and numeric examples using real ticker formats to apply directly to screening and analysis workflows.

• Understand the core formula and what each ratio measures in plain language.
• Learn how to use ratios together, valuation, profitability, liquidity, and leverage, to form a rounded view.
• See calculated examples using $TICKER-style symbols to practice on real companies.
• Get sector context: why a 'good' value differs between banks, tech, and industrials.
• Avoid common ratio pitfalls and learn better alternatives where applicable.

Seven Key Ratios Explained

1. Price-to-Earnings (P/E) Ratio

Formula: P/E = Market Price per Share / Earnings per Share (EPS).

The P/E ratio measures how much investors pay for a dollar of a company’s reported earnings. A high P/E implies high growth expectations or an expensive valuation; a low P/E can indicate undervaluation or weak future prospects.

Example: If $AAPL trades at $150 and trailing EPS is $6, P/E = 150 / 6 = 25. Compare this to sector peers, if the sector average is 20, $AAPL appears relatively expensive but may have higher growth or quality.

Interpretation tips:

• Use trailing P/E (TTM) for realized earnings and forward P/E for expected earnings.
• Compare to industry peers and historical averages, not the market alone.
• Be cautious with negative or near-zero EPS, P/E is meaningless in those cases.

2. Return on Equity (ROE)

Formula: ROE = Net Income / Shareholders’ Equity.

ROE shows how efficiently a company uses shareholders’ capital to generate profits. High ROE may indicate effective management or profitable business models; low ROE could point to inefficiency or capital-heavy industries.

Example: $JPM posts net income of $36 billion and average shareholders’ equity of $320 billion, ROE ≈ 36 / 320 = 11.25%. For banks, ROE in the high single digits to mid-teens is common; for software firms, higher ROEs (15%+) may be typical.

Interpretation tips:

• Watch for ROE boosted by excessive financial leverage, pair ROE with Debt-to-Equity.
• Compare ROE among firms with similar capital intensity and accounting rules.

3. Debt-to-Equity Ratio (D/E)

Formula: Debt-to-Equity = Total Liabilities / Shareholders’ Equity (or Total Debt / Equity).

D/E measures financial leverage: how much debt a company uses to finance assets relative to shareholders’ funds. Higher leverage increases risk (interest obligations) but can magnify returns when used prudently.

Example: $T has total debt of $150 billion and equity of $25 billion, D/E = 150 / 25 = 6.0, a high leverage typical for telecoms but risky if cash flow falters. Many non-financial firms maintain D/E < 1.0; utilities and telecoms often run higher.

Interpretation tips:

• Use industry benchmarks, banks and insurers have different capital structures and regulatory metrics.
• Check interest coverage (EBIT/Interest) alongside D/E to assess the ability to service debt.

4. Profit Margins: Gross, Operating, and Net

Formulas: Gross Margin = Gross Profit / Revenue. Operating Margin = Operating Income / Revenue. Net Margin = Net Income / Revenue.

Margins show how much of each revenue dollar is retained at successive stages of the income statement. Stable or expanding margins indicate pricing power and operational efficiency.

Example: $AMZN reports revenue of $500B, cost of goods sold (COGS) 350B (gross profit 150B), operating income 30B, net income 15B. Gross margin = 150/500 = 30%, operating margin = 30/500 = 6%, net margin = 15/500 = 3%.

Interpretation tips:

• High gross margin typically belongs to software and branded consumer goods; low gross margin is common in retail and commodity businesses.
• Watch margin trends, compressing margins can signal rising costs or pricing pressure.

5. Price-to-Book (P/B) Ratio

Formula: P/B = Market Price per Share / Book Value per Share (Book Value = Total Assets, Total Liabilities).

P/B compares market valuation to the accounting net asset value. A P/B < 1.0 may indicate the market values the assets below their book value, sometimes signaling value opportunities or asset quality issues.

Example: $DE (a heavy-capital manufacturer) has book value per share $80 and price $100, P/B = 100 / 80 = 1.25. Capital-intensive firms often trade near book; technology firms with intangible-heavy balance sheets can trade far above book.

Interpretation tips:

• P/B is most meaningful for asset-heavy businesses (banks, insurers, industrials).
• Intangibles and off-balance-sheet assets can distort P/B for modern tech firms.

6. Current Ratio

Formula: Current Ratio = Current Assets / Current Liabilities.

The current ratio measures short-term liquidity, the firm’s ability to meet obligations within a year. A ratio above 1 suggests sufficient short-term assets to cover short-term liabilities; however, excessively high ratios may indicate underutilized capital.

Example: $KO has current assets $20B and current liabilities $12B, current ratio = 20 / 12 = 1.67. That suggests comfortable near-term liquidity for operations and working capital needs.

Interpretation tips:

• For retailers, quick ratio (excludes inventory) can be more telling because inventory may not convert rapidly to cash.
• Seasonal businesses may have volatile current ratios, consider trailing averages.

7. PEG Ratio (Price/Earnings-to-Growth)

Formula: PEG = P/E Ratio / Annual EPS Growth Rate (expressed as a whole number, e.g., 20% growth = 20).

PEG normalizes P/E by expected growth. A PEG near 1 suggests valuation roughly matches growth expectations; below 1 can indicate undervaluation relative to growth, while above 1 may be expensive for the growth rate.

Example: $NVDA trades at P/E 60 with an expected EPS CAGR of 40% over the next 3, 5 years. PEG = 60 / 40 = 1.5, implying the market may be pricing a premium relative to that growth rate.

Interpretation tips:

• Use consensus analyst growth rates or company guidance; inconsistent or unsustainable growth assumptions will mislead PEG.
• PEG is less useful for cyclical businesses where single-year growth rates are volatile.

Putting Ratios Together: A Practical Workflow

Ratios are most powerful when used in combination rather than standalone. A simple workflow for screening and analysis:

1. Start with valuation: screen by P/E and P/B against sector medians.
2. Check profitability: examine gross, operating, and net margins and ROE for quality and efficiency.
3. Assess leverage and liquidity: review Debt-to-Equity and current ratio to gauge financial risk and resilience.
4. Adjust valuation view with growth: calculate PEG to incorporate expected growth rates.

Example scenario: You find a consumer goods stock with low P/E (12) and P/B (0.9). But margins have shrunk year-over-year and ROE fell from 18% to 8%. Debt-to-Equity jumped from 0.6 to 1.8. Those signs suggest the low multiples may reflect real deterioration rather than a bargain.

Real-World Examples (Numeric Walkthroughs)

Example 1: Growth tech vs. mature company

$NVDA (growth) vs. $KO (mature consumer brand), illustrative numbers:

• $NVDA: Price $480, EPS $8 => P/E 60. Expected EPS CAGR 40% => PEG = 60/40 = 1.5. High P/E justified only if growth sustains.
• $KO: Price $65, EPS $2.50 => P/E 26. EPS growth 5% => PEG = 26/5 = 5.2. Higher PEG implies slower growth relative to P/E.

Interpretation: A higher PEG for $KO reflects slower growth; $NVDA’s PEG near 1.5 suggests a premium but could be reasonable if execution and TAM materialize.

Example 2: Bank ROE and leverage

$JPM example: Net income normalized $36B, equity $320B => ROE ≈ 11.25%. Debt-to-Equity is less meaningful for banks, capital ratios (CET1) are used instead. Always adapt ratio choice to industry norms.

Common Mistakes to Avoid

• Relying on a single ratio: No single metric tells the whole story. Combine valuation, profitability, liquidity, and leverage measures.
• Comparing across unrelated industries: P/E, ROE, and D/E norms vary widely by sector, always compare to peers.
• Ignoring accounting differences: One-time gains, aggressive revenue recognition, or intangible-heavy balance sheets distort ratios. Adjust for one-offs where necessary.
• Using outdated or inconsistent growth rates for PEG: Always use a consistent, credible growth estimate (consensus or management guidance) and examine sensitivity.
• Misreading P/E with negative earnings: P/E is not meaningful for losses, use price-to-sales or enterprise-value measures instead.

FAQ

Q: When should I use trailing P/E vs. forward P/E?

A: Use trailing P/E (TTM) for realized earnings; it reflects what the market paid for past performance. Use forward P/E to capture expected earnings and future-oriented valuation, ideal during stable analyst coverage but sensitive to optimistic forecasts.

Q: Is a low P/B always a buying signal?

A: No. A low P/B can indicate undervaluation but may also reflect asset quality problems, declining prospects, or intangible-heavy businesses where book value understates economic value. Investigate the balance sheet and asset mix first.

Q: How do I adjust ratios for cyclical companies?

A: For cyclical firms, use normalized earnings (cycle-adjusted averages) or multi-year averages for margins and ROE. Compare valuation ratios to cycle-adjusted earnings to avoid misleading spikes or troughs.

Q: Can PEG be used for mature slow-growers?

A: PEG has limited value for mature slow-growers because small growth rates inflate the ratio and sensitivity to small changes is high. For these companies, focus on dividends, free cash flow yield, and P/B instead.

Bottom Line

Seven ratios, P/E, ROE, Debt-to-Equity, Profit Margins, P/B, Current Ratio, and PEG, form a compact toolkit for assessing valuation, profitability, leverage, liquidity, and growth expectations. Each ratio answers a specific question, but the strongest conclusions come from patterns across several metrics.

Next steps: pick a watchlist of 5, 10 stocks, compute these ratios yourself (or verify with trusted data sources), and compare results to sector medians and historical trends. Use the common mistakes checklist to avoid traps and iterate your process as you gather more company-specific context.

Continued practice, screening, calculating, and contextualizing, will make these ratios a reliable part of your analysis toolkit without replacing deeper due diligence on business models and competitive dynamics.