Part 2: Valuation Ratios - Is This Stock Cheap or Expensive?

How To Spot Bargains and Avoid Overpriced Hype

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Introduction: The Price vs Value Problem

You've analyzed the financial statements. The company is profitable, has low debt, and generates cash. Excellent! But there's one critical question left:

Is the stock price actually a good deal?

A great company can be a terrible investment if you overpay. Think of it like buying a house: a beautiful £500k home is a bargain... unless everyone else is only paying £300k for similar homes.

This is what you'll learn:
  • How to calculate key valuation ratios
  • What these ratios actually mean for your investment
  • How to compare stocks in the same industry
  • When to buy, hold, or avoid based on valuation

THE P/E RATIO: How Many Years To Get Your Money Back?

What It Means

P/E Ratio = Stock Price ÷ Earnings Per Share

Translation: How many years of profit would it take to pay back the stock price?

Real Example

Company X:
• Stock Price: £100
• Earnings Per Share: £5
• P/E Ratio: 20 (£100 ÷ £5)

This means you're paying £100 for £5 of annual profit. At this rate, it would take 20 years of profit to equal your investment.

What's A Good P/E Ratio?

It depends on the industry:

Industry Typical P/E Why
Tech (High Growth) 25-40 Investors expect rapid growth
Retail 15-25 Moderate growth expectations
Utilities 12-18 Slow growth, stable dividends
Banks 8-15 Cyclical, regulatory concerns

General Rules:

  • P/E under 15: Could be undervalued (or there's a problem)
  • P/E 15-25: Fair valuation for most industries
  • P/E over 30: Expensive (or high-growth expectations)
  • Negative P/E: Company is losing money
GRAPH 4: P/E Ratio Comparison by Industry

Real Comparison: Which Would You Buy?

NVIDIA vs INTEL (2023)

Metric NVIDIA Intel Analysis
Stock Price £400 £35 -
Earnings/Share £10 £2 -
P/E Ratio 40 17.5 NVIDIA is 2.3x more expensive
Revenue Growth 60% YoY 2% YoY NVIDIA growing much faster
Profit Margin 45% 15% NVIDIA much more profitable

NVIDIA (P/E = 40)

✓ Explosive growth in AI chips

✓ Dominant market position

❌ Expensive - any disappointment will crash the stock

Best for: Growth investors willing to pay premium

Intel (P/E = 17.5)

✓ Cheaper valuation

✓ Stable, established company

❌ Slow growth, losing market share

Best for: Value investors wanting steady dividends

NVIDIA vs Intel Valuation & Growth
The Verdict: NVIDIA's high P/E is justified IF they maintain growth. Intel is cheaper but for a reason - the business is stagnating. High P/E isn't always bad if growth supports it.

When P/E Ratios Lie

DON'T use P/E for:
  1. Unprofitable companies (negative earnings = meaningless P/E)
  2. Cyclical industries during down years (temporarily inflated P/E)
  3. Companies with one-time charges (distorts earnings)

Example: An oil company might have a P/E of 50 during low oil prices, but 8 during high prices. The P/E swings wildly based on commodity cycles, not company quality.

THE P/B RATIO: Are You Paying More Than It's Worth?

What It Means

P/B Ratio = Stock Price ÷ Book Value Per Share

Translation: How much are you paying compared to the company's net worth?

Book Value = Total Assets - Total Liabilities (from the Balance Sheet)

Real Example

Company Y:
• Stock Price: £50
• Book Value Per Share: £25
• P/B Ratio: 2.0 (£50 ÷ £25)

You're paying £50 for assets worth £25. That's a 2x premium above the company's net worth.

What's A Good P/B Ratio?

P/B Ratio Meaning When It's Normal
Under 1.0 Trading below net worth - potential bargain Distressed companies, banks in crisis
1.0 - 3.0 Fair valuation Most mature industries
3.0 - 10.0 Premium pricing Tech, brands with intangible value
Over 10.0 Extremely expensive Growth tech, minimal physical assets
Why do some companies trade at P/B of 10?

Because their value isn't in physical assets - it's in brands, patents, and intellectual property.

Example:

GRAPH 5: P/B Ratio by Industry

Real Comparison: Asset-Heavy vs Asset-Light

AMAZON vs WALMART

Metric Amazon Walmart
Stock Price £150 £160
Book Value/Share £18 £45
P/B Ratio 8.3 3.6
Business Model Cloud + E-commerce (tech) Physical retail stores
Why the difference?
• Walmart: Owns thousands of stores, inventory, trucks = high book value
• Amazon: Cloud software (AWS) creates massive value with minimal physical assets

Which to buy? P/B alone doesn't tell you - both can be good investments. Use P/B to compare companies in the SAME industry, not across industries.

THE PEG RATIO: The Secret Weapon For Growth Stocks

What It Means

PEG Ratio = P/E Ratio ÷ Expected Growth Rate

Translation: Are you overpaying for the growth you're getting?

This ratio adjusts the P/E for growth, making it perfect for comparing high-growth stocks.

Real Example

Company Z:
• P/E Ratio: 30
• Expected Growth Rate: 25% per year
• PEG Ratio: 1.2 (30 ÷ 25)

What's A Good PEG Ratio?

PEG Ratio Meaning Action
Under 1.0 Undervalued relative to growth ✓ Strong buy signal
1.0 - 1.5 Fairly valued ✓ Reasonable
1.5 - 2.0 Getting expensive ⚠️ Proceed with caution
Over 2.0 Overvalued ❌ Likely overpriced

The Golden Rule: PEG under 1.0 = potential bargain

Real Example: Tesla vs Traditional Automakers (2023)

Metric Tesla Toyota Ford
P/E Ratio 60 9 6
Expected Growth 25% 5% 3%
PEG Ratio 2.4 1.8 2.0
PEG Ratio Comparison: Who's Actually Cheaper?
What This Tells You:

Tesla (PEG = 2.4):
❌ Overvalued even accounting for growth
• Investors are TOO optimistic about future
• Risk: Any growth disappointment = major stock drop

Toyota (PEG = 1.8):
✓ Fairly valued for a mature automaker
• Slow but steady growth priced in

Ford (PEG = 2.0):
⚠️ Cheap P/E, but growth is so slow it's not actually a bargain

Best Value: Toyota offers the best risk-reward at PEG 1.8
GRAPH 6: PEG Ratio Sweet Spot

THE DIVIDEND YIELD: How Much Income Will You Get?

What It Means

Dividend Yield = (Annual Dividend Per Share ÷ Stock Price) × 100

Translation: What percentage return will you get in cash dividends each year?

Real Example

Company W:
• Stock Price: £100
• Annual Dividend: £4 per share
• Dividend Yield: 4% (£4 ÷ £100 × 100)

If you invest £10,000, you'll receive £400 per year in dividends.

What's A Good Dividend Yield?

Yield Meaning Risk Level
0-1% Growth company, reinvesting profits Low (if company is growing)
2-4% Healthy, mature company Low to moderate
4-6% High dividend, slower growth Moderate
Over 7% Warning sign - dividend might be cut High risk
Beware of "dividend traps": A 10% yield sounds amazing, but if the company cuts the dividend, you'll lose money on the stock price drop.
GRAPH 7: Dividend Yield vs Growth Quadrant

Real Comparison: Growth vs Income

APPLE vs AT&T

Metric Apple AT&T
Stock Price £180 £17
Annual Dividend £1 £1.20
Dividend Yield 0.6% 7.1%
Revenue Growth 8% -1%
P/E Ratio 28 6

Apple (0.6% yield)

• Growth-focused

• Reinvests profits into new products

Best for: Younger investors wanting price appreciation

AT&T (7.1% yield)

• Income-focused

• Mature, stable business

Best for: Retirees needing cash income

PUTTING IT ALL TOGETHER: The Valuation Scorecard

Let's analyze a real stock using all these ratios:

Case Study: Microsoft (2024)

Ratio Microsoft Industry Average Verdict
P/E Ratio 32 28 Slightly expensive
P/B Ratio 12 6 Premium for tech assets
PEG Ratio 1.5 2.0 ✓ Fair value for growth
Dividend Yield 0.8% 1.5% Low, but growing
Profit Margin 35% 15% ✓ Exceptional
Debt-to-Equity 0.4 1.2 ✓ Very healthy
Microsoft Valuation Scorecard
Overall Assessment:
✓ Premium valuation justified by quality
✓ PEG ratio shows fair price for growth
✓ Financial health is excellent
✓ Dividend growing steadily

Investment Decision: BUY - Despite high P/E and P/B, the quality and growth prospects justify the premium pricing.

THE COMPARISON FRAMEWORK: How To Choose Between Stocks

Step-by-Step Process

1. Screen for financial health (from Part 1):
  • Profitable?
  • Positive cash flow?
  • Manageable debt?
2. Calculate valuation ratios:
  • P/E, P/B, PEG, Dividend Yield
3. Compare to:
  • Industry averages
  • Direct competitors
  • Historical valuations
4. Make your decision:
  • Undervalued + Quality = Buy
  • Fairly valued + Growth = Hold
  • Overvalued = Wait or Avoid
GRAPH 8: The Valuation Matrix

COMMON VALUATION MISTAKES TO AVOID

Mistake #1: Using P/E for Unprofitable Companies

Wrong: "Company has negative P/E, must be cheap!"

Right: Use Price-to-Sales ratio for unprofitable growth companies

Mistake #2: Comparing Across Industries

Wrong: "Bank has P/E of 10, tech has 30, so bank is cheaper!"

Right: Banks always trade at lower P/E - compare within same industry

Mistake #3: Chasing High Dividend Yields

Wrong: "10% yield! Free money!"

Right: High yields often signal dividend cuts coming - check payout sustainability

Mistake #4: Ignoring Growth

Wrong: "P/E is 50, way too expensive!"

Right: Check PEG ratio - might be cheap if growing 60% per year

Mistake #5: Buying Based on One Ratio

Wrong: "Low P/E means automatic buy!"

Right: Use multiple ratios + financial statement analysis

PRACTICE EXERCISE: Which Stock Would You Buy?

You have £5,000 to invest. Analyze these three companies:

Metric Company A
"GrowthTech"		 Company B
"SteadyCorp"		 Company C
"ValueFind"
P/E Ratio 75 18 12
PEG Ratio 1.8 2.0 1.0
Revenue Growth 40% YoY 8% YoY 12% YoY
Profit Margin 15% 22% 18%
Dividend Yield 0% 3.5% 2.0%
Debt-to-Equity 0.3 0.8 1.2
Practice Exercise: Compare All Three Companies

Analysis:

Company A - "GrowthTech"

⚠️ Very high P/E but PEG is reasonable at 1.8

✓ Explosive 40% growth

✓ Low debt

❌ No dividend

Profile: High-risk, high-reward growth stock

Best for: Aggressive investors, 10+ year horizon

Company B - "SteadyCorp"

✓ Fair P/E at 18

⚠️ PEG slightly high at 2.0 (paying premium for slow growth)

✓ Excellent 22% margins

✓ 3.5% dividend

Profile: Quality mature company, but slightly overvalued

Best for: Income investors willing to pay for quality

Company C - "ValueFind"

✓✓ Low P/E at 12

✓✓ PEG at 1.0 = perfect fair value

✓ Solid 12% growth

✓ Good margins at 18%

✓ 2% dividend

⚠️ Slightly more debt but manageable

Profile: Best risk-reward balance

Best for: Most investors

The Verdict: WINNER - Company C "ValueFind"

Why?
• PEG of 1.0 means it's fairly priced for the growth
• Growing faster than Company B at a cheaper valuation
• Less risky than Company A
• Provides dividend income
• Best overall balance of value, quality, and growth

Smart Strategy: Put 60% in Company C, 20% in Company A (for growth exposure), 20% in Company B (for dividend income)

NEXT STEPS

You now know how to evaluate if stocks are cheap or expensive! But valuation is only half the battle.

Coming in Part 3: Industry Analysis & Competitive Moats

You'll learn:



Continue to Part 3 → ← Back to Part 1 Back to Overview

Remember: A "cheap" stock isn't always a good deal, and an "expensive" stock isn't always overpriced. Context matters - always analyze quality, growth prospects, and industry position alongside valuation.