Is This Stock Worth Buying?
Valuation is the art and science of determining what a stock is actually worth compared to its current price. A great company isn't a great investment if you overpay for it—and a mediocre company can be a great investment if you buy it at the right price. Understanding valuation helps you avoid overpaying and find opportunities the market has overlooked.
"Price is what you pay, value is what you get."
— Warren BuffettValuation Approaches Overview
| Approach | Methods | Best For | Limitations |
|---|---|---|---|
| Relative Valuation | P/E, P/B, P/S, EV/EBITDA | Comparing to peers | Entire sector can be over/undervalued |
| Intrinsic Valuation | DCF, DDM | Absolute worth estimate | Highly sensitive to assumptions |
| Asset-Based | Book value, liquidation value | Asset-heavy companies, distressed | Ignores earnings power |
1. P/E Ratio Analysis (Price-to-Earnings)
The Most Popular Valuation Metric
P/E = Stock Price ÷ Earnings Per Share (EPS)
The P/E ratio tells you how much investors are willing to pay for each dollar of earnings. It's essentially the "multiple" the market assigns to a company's earnings.
Low P/E (< 15)
Possibilities:
- Stock is undervalued (opportunity!)
- Company has structural problems
- Industry is out of favor
- Growth is slow or declining
- Cyclical company at earnings peak
Average P/E (15-25)
Possibilities:
- Fairly valued for stable companies
- Market has reasonable expectations
- Need to look at other factors
High P/E (> 25)
Possibilities:
- Strong growth expected
- Market is overly optimistic
- Could be a bubble
- Temporary earnings dip (depressed E)
Types of P/E Ratios
| Type | Definition | Use Case |
|---|---|---|
| Trailing P/E (TTM) | Price / Last 12 months earnings | Based on actual results—most common |
| Forward P/E | Price / Next 12 months estimated earnings | Based on analyst estimates—growth companies |
| Shiller P/E (CAPE) | Price / 10-year inflation-adjusted average earnings | Smooths out cycles—market valuation |
💡 How to Use P/E Properly
- Compare to company's historical P/E: Is it trading above or below its own average?
- Compare to industry average: Tech (25-35) vs Banks (10-15) vs Utilities (15-20)
- Compare to market average: S&P 500 historical average is ~16, currently ~20-25
- Look at forward vs trailing: Big difference? Earnings expected to change significantly
⚠️ P/E Pitfalls
- Doesn't work for unprofitable companies (negative earnings = meaningless P/E)
- Can be manipulated: One-time charges, accounting choices affect EPS
- Ignores balance sheet: Two companies with same P/E might have very different debt levels
- Cyclical trap: Cyclical stocks have LOW P/E at peak (sell signal) and HIGH P/E at trough (buy signal)
2. PEG Ratio (P/E to Growth)
Adjusting P/E for Growth
PEG = P/E Ratio ÷ Earnings Growth Rate
The PEG ratio adjusts P/E for expected growth. A high P/E isn't necessarily expensive if growth is high enough to justify it. A low P/E isn't necessarily cheap if growth is stagnant.
| PEG Range | Interpretation | Action |
|---|---|---|
| < 1 | Potentially undervalued—growth not priced in | Attractive opportunity if quality is good |
| = 1 | Fairly valued for growth | Fair price, need other factors |
| 1 - 2 | Might be slightly expensive or quality premium | Acceptable for great companies |
| > 2 | Expensive relative to growth | Caution—need strong thesis |
📊 PEG Examples
| Company | P/E | Growth Rate | PEG | Verdict |
|---|---|---|---|---|
| High Growth Tech | 50 | 40% | 1.25 | Reasonable for hypergrowth |
| Stable Consumer | 18 | 8% | 2.25 | Expensive for slow growth |
| Turnaround Play | 12 | 15% | 0.80 | Attractive if turnaround works |
| Value Trap | 8 | -5% | N/A | Declining—PEG doesn't apply |
💡 Peter Lynch's Rule
Legendary investor Peter Lynch popularized PEG and suggested that "a fairly priced company has a PEG of 1, meaning you're paying $1 for every percentage point of growth." He looked for stocks with PEG < 1 as potential bargains.
3. Price-to-Book (P/B) Ratio
What Are the Assets Worth?
P/B = Stock Price ÷ Book Value Per Share
Book Value = Total Assets - Total Liabilities (= Shareholders' Equity)
P/B compares the market's valuation to the company's accounting book value. It answers: "How much am I paying for each dollar of net assets?"
P/B < 1 (Trading Below Book Value)
Possibilities:
- Genuinely undervalued (opportunity)
- Assets are impaired/overvalued on books
- Company is losing money (destroying book value)
- Market expects writedowns
P/B 1-3
Normal range for most companies
P/B > 3
Premium valuation—usually for asset-light companies with strong earnings (tech, services)
| Industry | Typical P/B Range | Why? |
|---|---|---|
| Banks | 0.8 - 1.5 | Asset values are close to market values |
| Insurance | 1.0 - 2.0 | Book value reflects investment portfolio |
| Manufacturing | 1.5 - 3.0 | Physical assets plus earnings power |
| Tech/Software | 5.0 - 20+ | Value is in intangibles (IP, talent), not physical assets |
⚠️ P/B Limitations
- Book value can be distorted by accounting (goodwill, intangibles)
- Doesn't work well for asset-light companies (tech, services)
- Historical cost accounting may not reflect current asset values
- Low P/B can be a "value trap" if assets are impaired
4. Price-to-Sales (P/S) Ratio
When Earnings Don't Exist
P/S = Market Cap ÷ Total Revenue
or
P/S = Stock Price ÷ Revenue Per Share
P/S is useful for valuing companies that aren't yet profitable. Revenue is harder to manipulate than earnings and more stable for young companies.
| P/S Range | Interpretation | Context |
|---|---|---|
| < 1 | Potentially undervalued | Trading for less than annual revenue |
| 1 - 3 | Reasonable for most companies | Normal range |
| 3 - 10 | Premium valuation | Acceptable for high-growth, high-margin |
| > 10 | Very expensive | Needs exceptional growth to justify |
💡 Combine P/S with Gross Margin
A company with P/S of 5 and 80% gross margins is actually cheaper than one with P/S of 3 and 30% gross margins. High-margin businesses deserve higher P/S ratios because more revenue converts to profit.
5. EV/EBITDA
The Professional's Choice
EV = Market Cap + Total Debt - Cash
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
EV/EBITDA = Enterprise Value ÷ EBITDA
EV/EBITDA is preferred by professional investors and in M&A because:
- Enterprise Value accounts for debt (unlike market cap alone)
- EBITDA is closer to cash flow than net income
- Allows comparison of companies with different capital structures
- Used in leveraged buyout analysis
| EV/EBITDA Range | Interpretation |
|---|---|
| < 8 | Potentially undervalued, good for value investors |
| 8 - 12 | Fair value for most industries |
| 12 - 20 | Premium valuation, growth expected |
| > 20 | Very expensive, needs justification |
6. Discounted Cash Flow (DCF)
The "Gold Standard" of Intrinsic Valuation
DCF calculates what all future cash flows are worth today. It's the most theoretically correct method—a stock's value is the present value of all future cash it will generate.
📊 Simplified DCF Example
Company XYZ projections:
- Current FCF: $100 million
- FCF growth: 10% for 5 years, then 3% forever
- Discount rate: 10%
- Shares outstanding: 10 million
Result: Intrinsic value ≈ $150 per share
If current stock price is $100, there's 50% upside (margin of safety)
⚠️ DCF Limitations
- Garbage in, garbage out: Results depend entirely on assumptions
- Sensitivity: Small changes in growth or discount rate dramatically change the result
- Difficult for young companies: Hard to project FCF for unpredictable businesses
- Best as sanity check: Use ranges, not precise numbers
💡 Practical DCF Tips
- Run multiple scenarios (bull case, base case, bear case)
- Use conservative assumptions (lower growth, higher discount rate)
- Don't trust precision—think in ranges
- Compare your intrinsic value to current price for margin of safety
7. Dividend Discount Model (DDM)
For Dividend-Paying Stocks
Intrinsic Value = Dividend / (Required Return - Dividend Growth Rate)
The Gordon Growth Model (simplest DDM)
📊 DDM Example
A stock pays $2 dividend, dividends grow 5% annually, you require 10% return:
Value = $2 / (0.10 - 0.05) = $2 / 0.05 = $40 per share
Best for: Mature, stable dividend payers (utilities, REITs, dividend aristocrats)
Not suitable for: Non-dividend companies, irregular dividends, high growth
Sector-Specific Metrics
| Sector | Key Metrics | Why? |
|---|---|---|
| Banks | P/B, P/TBV, ROE, NIM | Asset values matter, earnings volatility |
| Insurance | P/B, Combined Ratio | Book value reflects investments |
| REITs | P/FFO, P/AFFO, Dividend Yield | FFO (Funds From Operations) is better than earnings |
| Telecom | EV/EBITDA, Debt/EBITDA | Capital intensive, debt levels matter |
| Tech/SaaS | P/S, EV/Revenue, Rule of 40 | Often unprofitable, revenue growth key |
| Retail | P/E, Same-store sales, Inventory turnover | Margins matter, inventory efficiency |
| Biotech | EV vs Cash, Pipeline value | Binary outcomes, cash runway critical |
Putting It All Together
🎯 Complete Valuation Framework
- Understand the business: What does it do? How does it make money?
- Check multiple metrics: P/E, PEG, P/B, P/S, EV/EBITDA
- Compare to history: Is it expensive vs its own past?
- Compare to peers: Is it expensive vs competitors?
- Consider growth: Does valuation match growth prospects?
- Run a DCF: What's the intrinsic value based on cash flows?
- Calculate margin of safety: Buy significantly below intrinsic value
💡 The Margin of Safety
Benjamin Graham's most important concept: always buy at a significant discount to your estimate of intrinsic value. If you estimate a stock is worth $100:
- Buy at $70 (30% margin of safety) for moderate-risk investments
- Buy at $50 (50% margin of safety) for higher-risk or uncertain situations
This protects you from errors in your analysis and provides better returns when you're right.
Key Takeaways
- No single metric tells the whole story—use multiple valuation methods
- P/E is most common but has limitations (cyclical companies, unprofitable)
- PEG adjusts for growth: PEG < 1 is potentially attractive
- P/B works best for asset-heavy industries (banks, insurance)
- P/S useful for unprofitable growth companies
- EV/EBITDA is the professional's choice—accounts for debt
- DCF is theoretically best but highly sensitive to assumptions
- Compare to company's history AND industry peers
- Always require a margin of safety—buy below intrinsic value