Beginner's Guide to Stock Valuation: P/E, PEG, P/B

Introduction

Stock valuation is the process of estimating what a share of a company is worth using numbers and ratios. You don't need a finance degree to learn the basics, but a few simple metrics can help you decide whether a stock looks inexpensive or expensive compared with peers.

How do you know if a stock is cheap or overpriced? Which measures should you trust when you compare companies? In this guide you'll learn what price-to-earnings, price/earnings-to-growth, and price-to-book mean, how to calculate them, and how to use them together to make smarter comparisons.

• Learn what P/E, PEG, and P/B measure and what they imply about value
• See step-by-step calculations using clear examples with $AAPL and $MSFT style comparisons
• Understand how growth, profitability, and sector norms change interpretation
• Get practical rules of thumb and common mistakes to avoid
• Find next steps for applying valuation metrics in your research

Understanding Valuation Basics

Valuation metrics link a stock's market price to the company's financial performance or balance sheet. They are shorthand tools that help you compare companies of different sizes and industries using the same yardstick.

Remember, a single number rarely tells the whole story. Ratios are most useful when you compare similar companies or look at a company's historical range. You will learn why context matters and what to check beyond the headline number.

Key Valuation Ratios: P/E, PEG, and P/B

Here are the three core ratios beginners should start with. Each ratio answers a different question about value and risk. You'll see how to calculate each one and what it usually signals.

Price-to-Earnings Ratio, P/E

Definition: P/E equals the current share price divided by earnings per share. It shows how much investors are willing to pay for one dollar of a company's earnings.

Calculation: P/E = Share Price / Earnings Per Share. If $AAPL trades at 150 dollars and earnings per share are 5 dollars, P/E is 150 divided by 5, or 30.

What it tells you: A high P/E often means the market expects higher future growth. A low P/E might indicate a company is undervalued or facing problems. Compare P/E to peers and the company's own history to interpret it.

Price/Earnings-to-Growth Ratio, PEG

Definition: PEG adjusts the P/E for expected growth in earnings. It helps you see whether a higher P/E is justified by faster growth.

Calculation: PEG = P/E divided by annual earnings growth rate. If P/E is 30 and expected growth is 15 percent per year, PEG is 30 divided by 15, or 2. A PEG around 1 is often considered fair value, below 1 could mean undervalued, and above 1 may be expensive, but that depends on other factors.

What it tells you: PEG gives a growth-adjusted view of valuation. Use analyst or company guidance for reasonable growth estimates, and check multiple sources so you don't rely on a single projection.

Price-to-Book Ratio, P/B

Definition: P/B compares market price to the company's book value on the balance sheet. Book value equals assets minus liabilities, effectively the accounting net worth.

Calculation: P/B = Market Capitalization divided by Book Value. Or on a per-share basis, P/B = Share Price / Book Value Per Share. If a stock costs 40 dollars and book value per share is 20 dollars, P/B is 2.

What it tells you: P/B is especially useful for financial firms and asset-heavy companies. A P/B below 1 can mean the market values the company lower than its accounting net worth, but you should check asset quality and off-balance items.

How to Use Ratios to Compare Stocks

Ratios are comparative tools. You use them to contrast similar companies or to track how a single company moves through its business cycle. Here are practical steps to guide you.

1. Define the peer group. Compare companies in the same industry with similar business models, for example $AAPL and $MSFT are both large tech firms but their businesses differ, so select comparable peers.
2. Pick the right metric for the company type. Use P/B for banks and insurers, use P/E and PEG for growth companies, and consider EV/EBITDA for capital-intensive firms.
3. Look at ranges and medians. Check the peer group's median P/E and where your stock sits in that range.
4. Use multiple metrics together. A low P/E with a weak PEG may signal low expected growth, while a high P/E with a strong PEG may be justified.

Example Comparison

Imagine Company A trades at $120 with EPS of $4 and expected earnings growth of 10 percent. Company B trades at $200 with EPS of $8 and expected growth of 20 percent.

Compute P/E for A: 120 divided by 4 equals 30. P/E for B: 200 divided by 8 equals 25. At first glance B has a lower P/E.

Now compute PEG. PEG A: 30 divided by 10 percent equals 3. PEG B: 25 divided by 20 percent equals 1.25. After adjusting for growth, Company B looks relatively cheaper because its higher growth helps justify the price.

Putting Ratios in Context: Sector, Growth, and Quality

Sectors have different typical valuations. Technology companies often trade at higher P/Es than utilities. You must compare within sectors and consider where the economy is in the cycle.

Growth and profitability also matter. Two companies with the same P/E can be very different if one has stable cash flow and high margins while the other has thin margins and volatile results. Quality metrics to check include return on equity, profit margins, debt levels, and cash flow.

Use Case: Tech Versus Financials

For banks and financial firms, book value is a central measure because assets and liabilities drive their value. For cloud software companies, earnings can be distorted by high up-front investments and stock-based compensation, so P/E should be used with caution.

Always ask, what is driving the difference in ratios? Higher P/E could reflect genuinely higher growth or simply hype. Higher P/B in an asset-light business may be meaningless if book assets don't capture intangible value.

Real-World Example: Comparing $AAPL and $MSFT Style Stocks

Consider two large technology names, here labeled TechCo1 and TechCo2 to keep this evergreen. TechCo1 has a price of 150 dollars, EPS of 6 dollars, and expected earnings growth of 12 percent. TechCo2 has a price of 250 dollars, EPS of 10 dollars, and expected growth of 18 percent.

TechCo1 P/E = 150 divided by 6, equals 25. TechCo2 P/E = 250 divided by 10, equals 25 as well. On P/E alone they look equal.

Now add PEG. TechCo1 PEG = 25 divided by 12, about 2.1. TechCo2 PEG = 25 divided by 18, about 1.4. Adjusting for growth, TechCo2 looks more attractive because higher growth makes the same P/E more justified.

Next check P/B and balance sheet strength. If TechCo1 has book value per share of 20 dollars, P/B = 7.5. If TechCo2 has book value per share of 30 dollars, P/B = 8.3. High P/B numbers are common in tech because intangible assets and brand value are not fully captured on the balance sheet.

Finally, consider cash flow and debt. If TechCo2 has stronger free cash flow and lower debt, that improves its quality picture, supporting a higher PEG tolerance. This layered approach gives you a more complete view than any single ratio.

Common Mistakes to Avoid

• Relying on a single ratio, like P/E, without context. Combine metrics and check industry norms to avoid misleading conclusions.
• Using inconsistent earnings or growth figures. Make sure you compare trailing or forward numbers consistently and use reliable analyst estimates.
• Ignoring business models and accounting differences. Some industries report earnings differently, so adjust your expectations accordingly.
• Overlooking balance sheet quality. A low P/B might hide bad assets or hidden liabilities. Read the notes to the financial statements.

FAQ

Q: What is the difference between trailing P/E and forward P/E?

A: Trailing P/E uses the last 12 months of reported earnings, while forward P/E uses analyst estimates for the next 12 months. Trailing is historical, forward is based on expectations, so use the one that best matches your comparison and be aware of estimate uncertainty.

Q: When is PEG more useful than P/E?

A: PEG is more useful when companies have different growth rates. It adjusts the P/E for expected growth and helps you compare a high-growth stock to a slower grower on a similar footing.

Q: Can P/B be negative and what does that mean?

A: Yes, P/B can be negative if book value is negative because liabilities exceed assets. That flags financial distress or heavy intangible write-offs and warrants careful analysis of why book value is negative.

Q: Are there industries where these ratios don't work well?

A: Yes, for early-stage startups, highly cyclical companies, and firms with irregular accounting charges, standard ratios can be misleading. Use alternative metrics like revenue multiples, EV/EBITDA, or unit economics for those cases.

Bottom Line

Valuation ratios like P/E, PEG, and P/B are practical tools that help you compare companies and set expectations about future returns. They are quick ways to screen stocks, but they are not definitive on their own.

Start by comparing similar companies, use multiple metrics, and always check the quality of earnings and the balance sheet. If you want to take the next step, practice calculating these ratios on companies you follow, and track how market prices and ratios move over time. At the end of the day, these metrics will help you ask better questions and make clearer decisions as you build your investment knowledge.