Cheap stocks aren’t always bargains; 5 valuation ratios every investor must track
Different sectors use different valuation metrics because business models vary. Investors therefore need to understand not just valuation multiples, but the logic behind them. P/E multiple, PEG ratio, P/S ratio, price-to-book value, EV/Ebitda are ...
High-growth companies often report losses in their early years as they spend heavily on expansion, logistics and technology. In such cases, the P/S ratio compares a company’s market value with its revenues.
In equity markets, the stock prices are readily visible, but it is the underlying value that truly matters. Is the stock really worth? Is it cheap or expensive? For many retail investors, distinguishing between the two is not straightforward. Absolute valuation methods such as discounted cash flow (DCF) rely on concepts like weighted average cost of capital (WACC), terminal value, and discount rates, which can make investing appear overly technical.
While DCF models are widely respected in finance, they depend heavily on assumptions about growth, profitability, and interest rates. Even small changes in these assumptions can dramatically alter valuation. This is one reason why relative valuation remains the most widely used framework in day-to-day market discussions.
Relative valuation is simpler and more intuitive. Instead of forecasting cash flows, it compares a company with similar listed peers using valuation multiples, asking a basic question: how much investors are paying for a company’s performance versus its peers? At its core, it assumes similar businesses should trade at similar valuations. But relative valuation comes with a caveat: a stock is not necessarily attractive because it trades at a lower multiple, nor overvalued simply because it trades at a premium.
Consider two companies: one trades at 50 times earnings and another at 20 times. The cheaper-looking stock may seem attractive, but if the former is growing profits at 35–40% annually while the latter faces weak demand, falling margins, or balance sheet stress, the premium valuation may simply reflect stronger fundamentals and better long-term prospects.
Different sectors use different valuation metrics because business models vary. Investors therefore need to understand not just valuation multiples, but the logic behind them. Here are some commonly used relative valuation metrics:
Price to earnings (P/E) multiple: The investors’ favourite
It compares a company’s share price with its earnings per share (EPS), showing how much investors pay for every rupee of profit. For instance, if a stock trades at Rs.500 and earns Rs.25 per share, its P/E ratio is 20.
Where it works best
Mature and stable businesses
Fast-Moving Consumer Goods, Information Technology, consumer goods, and pharmaceuticals
What works?
Easy to understand, widely available
Useful for comparing similar profitable businesses
Reflects market expectations around growth and profitability
What doesn’t?
Not useful when profits are negative or highly volatile
Earnings can be influenced by accounting adjustments
A low P/E doesn’t always signal undervaluation and high P/E may simply reflect stronger future growth expectations
PEG ratio (price/earnings to growth): Linking P/E with growth
The PEG ratio adjusts the P/E for earnings growth and shows how much investors are paying for future growth. A PEG of 1 is often seen as fair, while a much higher ratio may indicate overpaying for growth.
Where it works best
Fast-growing businesses/sectors
What works?
Helps assess whether high P/E valuations are justified
Connects valuation with earnings growth expectations
Useful in comparing growth companies.
What doesn’t?
Growth estimates can be uncertain Overly optimistic assumptions can distort valuations.
Price to sales (P/S) ratio: Pricing growth before profitability
High-growth companies often report losses in their early years as they spend heavily on expansion, logistics and technology. In such cases, the P/S ratio compares a company’s market value with its revenues.
Where it works best
Internet and technology companies E-commerce and platform businesses, and startups and early-stage growth firms
What works?
Useful for high-growth businesses that are not yet profitable
Revenue is generally harder to manipulate than earnings
Helps compare companies focused on scale and market share
What doesn’t?
Revenue growth alone does not guarantee profitability
Ignores margins and operating efficiency
A company can grow sales rapidly while continuing to lose money
A quick guide to valuation multiples
ADVERTISEMENT
Note: P/E: price to earnings, PEG: price to earnings growth, P/S: price to sales, P/BV: price to book value,EV/Ebitda: enterprise value to earnings before interest, taxes, depreciation and amortisation.
Price-to-book value (P/BV): Preferred metric for banks
Unlike manufacturers or tech firms, a bank’s business is its balance sheet. It borrows through deposits and lends via loans, with the difference between assets and liabilities forming its book value, or net worth. The P/BV ratio compares a bank’s market price with its per-share book value. If a bank’s book value per share is Rs.200 and the stock trades at Rs.300, the P/BV is 1.5x — investors are paying Rs.1.50 for every Rs.1 of the bank’s net worth. A P/BV above 1 reflects confidence in the bank’s ability to generate strong returns on its capital. A P/BV below 1 signals that the market doubts whether the bank’s assets are actually worth what the books say. In the banking sector, P/BV is therefore always read alongside Return on Equity (RoE).
Where it works best
Banks, Non-Banking Finance Companies (NBFC), and other financial institutions
What works?
Directly reflects the strength of the balance sheet
Useful for assessing capital adequacy and financial stability
Helps compare lenders with similar business models
What doesn’t?
Book value is backward-looking and may not capture future earnings potential
Asset quality problems, such as rising bad loans, can make book value misleading
A low P/BV bank may look cheap on paper, but it could be masking deeper balance sheet stress. The ratio works best when read alongside asset quality data and return ratios, not in isolation.
Enterprise value-to-Ebitda (EV/Ebitda): For capitalintensive businesses
When you buy a company, you are not just paying for its shares , you are also inheriting its debts. Enterprise Value (EV) reflects the true cost of buying a company — market cap plus debt, minus cash. So, two companies with similar market caps can have very different EVs.
Ebitda — earnings before interest, taxes, depreciation, and amortisation — strips away financing decisions and accounting charges to show what the core business is actually earning from its operations. Interest depends on the amount of debt a company carries. Depreciation reflects past investments, not current cash. Removing these gives a cleaner, more comparable picture of operating performance across companies.
EV/Ebitda asks: if you bought the entire business, including its debt, how many years of operating earnings would it take to recover the cost? A 5x multiple means five years. It is useful in capital-intensive sectors where high debt can make P/E ratios misleading.
