A share price of 300 says nothing about whether a stock is expensive. What matters is what you get for that price: the profits, the cash and the assets behind each share. Three classic ratios answer that question from three different angles.
1. The P/E ratio: how many years of profit you are paying
The P/E ratio (price-to-earnings) divides the share price by the profit per share over the last year:
P/E = share price / earnings per share
A P/E of 15 means you pay 15 times the company's annual profit. Put another way: if profits stayed the same, it would take 15 years of profit to equal the price.
How to read it:
- A low P/E can mean a cheap company, or one whose profits the market expects to fall.
- A high P/E can mean an expensive company, or one whose profits the market expects to grow quickly.
Its traps:
- It only works with profits. A company that loses money has no meaningful P/E.
- Profit can be distorted by one-off items: the sale of a business, a write-down, a tax effect.
- It does not travel well between sectors. A P/E of 25 is ordinary for some technology companies and very high for a bank.
2. Free cash flow yield: how much cash the business really generates
Accounting profit and cash are not the same thing. Free cash flow is the cash a company has left after paying for its operations and the investments it needs to keep running. It is the money that can be used to pay dividends, buy back shares, reduce debt or grow.
The free cash flow yield relates it to the company's market value:
FCF yield = free cash flow / market capitalisation
A yield of 6% means that, at today's price, the business generates each year cash equivalent to 6% of what it is worth on the stock market.
Why it is useful: cash is harder to dress up than accounting profit. A company with good profits and weak free cash flow deserves a closer look.
Its traps:
- A company investing heavily to grow can have low free cash flow today without that being a bad sign.
- One year can be unusual. A large investment or the timing of a payment can move it a lot.
3. Price-to-book: how much you pay for the assets
Book value is what would be left for shareholders, according to the accounts, if the company sold its assets and paid its debts. Price-to-book (P/B) compares the share price with that value per share:
P/B = share price / book value per share
A P/B of 1 means the market values the company at exactly its accounting net worth. Below 1, at less than that.
Where it is most useful: in companies whose value lies largely in their balance sheet, such as banks, insurers or industrial groups.
Its traps:
- Many valuable things are not on the balance sheet. A software company or a brand is worth much more than its accounting assets, so its P/B is naturally high.
- Buybacks can make it strange. A company that has bought back many shares can have a very small, or even negative, book value while being highly profitable.
Why use the three together
Each ratio sees one side of the company and each one has blind spots. Used together they balance each other:
A stock that looks cheap on all three is a different case from one that looks cheap on only one of them.
Cheap is not the same as good
The most common mistake in valuation is the value trap: a stock that looks cheap because the business is deteriorating. Low ratios are a reason to look closer, not a reason to buy.
That is why price should be read next to quality: how profitable the business is, how much debt it carries and how stable its earnings are.
How we use these ratios at InbestPlanners
The value ranking orders the covered companies by a value score that combines these three measures: P/E, free cash flow yield and price-to-book. The quality ranking looks at the other side: profitability, return on equity, debt and earnings stability. The 360 Analysis puts value, quality, dividend and the technical picture side by side for each company.
The value score describes price, not timing: neither of our signal methods uses it to decide an entry. The full description is on the methodology page.
In short
- P/E measures how many years of profit you pay; it fails with losses and one-off items.
- Free cash flow yield measures the cash the business really generates at today's price.
- Price-to-book compares price with accounting assets; it suits banks better than software.
- Use them together, and always next to the quality of the business.
This content is for educational purposes only and does not constitute financial advice. Past performance does not guarantee future results.