Most investors know they should "research a stock" before buying. Fewer know exactly what to look at. The three most important valuation ratios — price-to-earnings (P/E), price-to-book (P/B), and earnings per share (EPS) — each answer a different question about what a stock is worth and why. Used together, they form a complete first-pass analysis framework. Used in isolation, each one can mislead.
Step 1: Earnings Per Share (EPS) — The Foundation
EPS = net income ÷ diluted shares outstanding. It's the single most important bottom-line number for stock analysis. When you buy a share of stock, you are buying a proportional claim on the company's earnings — and EPS tells you exactly how much earnings that claim represents per share.
Always use diluted EPS, not basic EPS. Diluted EPS includes all potentially dilutive securities — stock options, warrants, convertible debt — and represents the worst-case earnings per share assuming all those securities are converted. For tech companies with heavy stock-based compensation, diluted EPS can be meaningfully lower than basic EPS.
Trailing vs. Forward EPS: Trailing EPS uses the last 12 months of actual reported earnings (reliable, backward-looking). Forward EPS uses analyst consensus estimates for the next 12 months (more relevant for fast-growers, but subject to forecast error). Use trailing for stable companies; forward when current earnings dramatically understate near-future earnings power due to growth.
EPS growth rate is what drives long-run stock returns. A company growing EPS at 15%/year will double earnings in ~5 years; at 10%/year, in ~7 years. The EPS growth calculator projects future EPS at any growth rate and shows the implied stock price at a given exit P/E multiple.
Step 2: Price-to-Earnings (P/E) — What You're Paying
P/E = stock price ÷ EPS. It tells you how much the market pays for each dollar of earnings. A P/E of 20 means $20 paid per $1 of annual earnings. This is the most widely used valuation metric and the starting point for nearly all stock analysis.
The S&P 500 long-run average P/E is approximately 15–17x, but context matters enormously:
- Interest rates: When rates are low, future earnings are worth more in present value terms, supporting higher P/E multiples. The 2010–2020 period of near-zero rates contributed to 22–25x average market P/E. When rates rise, P/E multiples tend to compress.
- Sector: Technology companies trade at 25–35x P/E because they grow faster and have higher margins. Banks trade at 12–15x because their earnings are more cyclical. Always compare P/E within the same sector.
- Growth rate: A 30x P/E on a company growing EPS at 30%/year can be cheaper than a 15x P/E on a company growing at 5%/year. Use the PEG ratio to normalize for growth.
Use the P/E ratio calculator to compare a stock's multiple to sector averages, see the PEG ratio, and find the implied fair price at multiple P/E targets (12x, 17x, 20x, 25x).
Step 3: The PEG Ratio — P/E Adjusted for Growth
PEG = P/E ÷ annual EPS growth rate. Peter Lynch popularized this ratio as a quick way to check whether a stock's multiple is justified by its growth. A PEG of 1.0 is roughly "fair value" — you're paying one dollar of multiple for each percentage point of growth. PEG below 1.0 may signal undervaluation; PEG above 2.0 may indicate you're overpaying for growth.
Example: Stock A has a P/E of 28x and grows EPS at 28% per year → PEG = 1.0. Stock B has a P/E of 15x and grows EPS at 5% per year → PEG = 3.0. Despite the lower P/E, Stock B is more expensive on a growth-adjusted basis.
PEG works best for mid-growth companies (10%–30% EPS growth). It's less reliable for very high-growth companies (40%+, where PEG near 1.0 may still be expensive) and for no-growth value stocks (where PEG becomes meaningless).
Step 4: Price-to-Book (P/B) — What the Balance Sheet Says
P/B = stock price ÷ book value per share. Book value is total shareholder equity divided by shares outstanding — what shareholders would theoretically receive if the company were liquidated. P/B tells you how much premium the market assigns above accounting net worth.
P/B is most useful for asset-heavy businesses: banks, insurance, real estate, utilities, manufacturers. For these companies, the balance sheet closely tracks economic value. A bank trading at 0.8x P/B is trading below its accounting net worth — which could mean deep value or concerns about asset quality.
P/B is less useful for asset-light businesses (software, consulting, consumer brands) where most of the value is in IP, brand, and customer relationships that don't appear on a GAAP balance sheet at market value. A software company at 15x P/B can be entirely reasonable.
The most useful signal: ROE vs. P/B. A company earning 25% return on equity deserves a higher P/B than one earning 8%. The formula: fair P/B ≈ ROE ÷ required return. If you require 10% and the company earns 20% ROE, a 2.0x P/B is fair. Use the price-to-book calculator to compute the Graham Number and ROE-implied fair P/B.
Putting It Together: A 3-Ratio Framework
| Signal | EPS | P/E / PEG | P/B + ROE | Interpretation |
|---|---|---|---|---|
| Growth compounder | ↑↑ | High P/E, low PEG | High P/B, high ROE | Premium justified by earnings growth + quality |
| Value opportunity | Stable | Low P/E, low PEG | Low P/B vs. ROE | Potential undervaluation; check earnings trend |
| Value trap | ↓ | Low P/E (looks cheap) | Low P/B, declining ROE | Earnings deteriorating; "cheap" gets cheaper |
| Speculative excess | Negative | N/A (no earnings) | Very high P/B | Story-driven valuation; high risk, use P/S instead |
For a deeper dive into what makes a P/E "good" or "expensive" across different market environments, the P/E ratio guide covers sector benchmarks and historical S&P 500 averages in detail. And for the growth vs. value investing debate — when does each style outperform, and how do you decide which approach fits your portfolio? — see the growth vs. value investing guide.