How To Use Ratios to Determine if a Stock Is Overvalued or Undervalued

For investors in the equity markets, determining a stock's intrinsic value is important in trying to determine whether it is over- or under-valued. Intrinsic value is the calculated (or perceived) value of a company, taking into account all sorts of factors, and using fundamental analysis. The intrinsic value may (or may not) be different than the current market value.

Many investors and analysts use a variety of statistical ratios to determine intrinsic value. Here are some of the most popular:

Valuations based on the dividend discount model involve determining the net present value of a company’s future dividend payments. The valuations calculated from a discount cash flow model seek to value a company today based on projected future cash flow. Other models take a more comparative approach, such as looking at P/E, P/B, and EV/EBITDA multiples, which can be benchmarked against other companies in the same or similar sectors.

For example, the lower a company's P/E ratio, the more value that stock is likely to provide. Meanwhile, companies with higher P/E ratios may not be overvalued if their earnings and revenue are growing at an amplified pace. Using valuation ratios can be an effective means to help determine if a stock is undervalued or overvalued relative to their competitors, but there are reasons to look beyond past performance numbers when evaluating whether a stock makes a good investment moving forward.

Is asking whether a stock is overvalued or undervalued the right question when considering an investment? Mark Hebner, founder and president of Index Fund Advisors in Irvine, Calif., warns against the various ways to attempt to determine a stock’s intrinsic value and assumptions about its future rate of return:

“I highly recommend that you do not engage in this practice," said Hebner. "Why do I say that? Realize that millions of analysts, professional investors, etc. around the world are engaging in the exact same process that I just described. They are buying and selling based on what they believe is the 'intrinsic value' of that stock.”

This means that, in a very real sense, the process of valuation has already been assessed by millions of investors and analysts. 

Some companies don't have earnings, but do have revenues. In such cases, investors can revert to the price-to-sales (P/S) ratio. P/S ratio is figured dividing the current stock price by the sales per share. The current stock price can be found by plugging the stock symbol into any major finance website. The sales per share metric is calculated as dividing a company’s sales by the number of outstanding shares. A low P/S ratio would be considered "cheap," and a high P/S is "expensive."

Price-to-dividend ratio is primarily used for analyzing dividend stocks. This ratio indicates how much you have to pay to receive $1 in dividend payments. This ratio is most useful in comparing a stock's value against itself over time or against other dividend-paying stocks.

Enterprise value is an alternative metric to market capitalization. The main difference is that it factors debt into the equation. Calculate EV by adding market cap to total debt (including preferred shares and minority interest) and subtracting cash and cash equivalents. Some favor this calculation in valuing companies that could be taken over, as debt and cash are primary factors in any M&A transaction.

A stock's PEG ratio is a stock's price-to-earnings (P/E) ratio, divided by the growth rate of its earnings for a specified time period. It an important piece of data to many in the financial industry as it takes a company's earnings growth into account, and tends to provide investors with a bigger picture view of future profitability compared to the P/E ratio.

While a low P/E ratio may make a stock look like it's worth buying, factoring in the growth rate may tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The degree to which a PEG ratio value indicates an over or underpriced stock varies by industry and by company type.

The accuracy of the PEG ratio depends on the accuracy and reliability of the inputs. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. To distinguish between calculation methods using future growth and historical growth, the terms "forward PEG" and "trailing PEG" are sometimes used.

Generally, when a PEG ratio comes in lower relative to its peers, the more the stock may be undervalued based on its earnings performance. A PEG ratio below one is typically thought to indicate that a stock may be underpriced, but this can vary by industry.

Intrinsic value, and the ratios that attempt to measure it, should only be viewed in the context of a company's whole story. It's also important to consider an investor's financial goals and risk tolerance, as well as the risk-reward potential indicated by other types of analysis.