A Snapshot of Current Stock Valuations

Our A+ Investor Value Grade uses percentile rankings to determine how cheap or expensive a stock is. Stocks are ranked based on whether they are cheap or expensive relative to all other stocks. The score underlying each grade is a composite ranking of up to six valuation ratios, including the price-earnings (P/E) ratio or the price-to-book-value (P/B) ratio.

The Value Grade has its basis in academic research. Datasets, like those provided by Dartmouth professor Kenneth French, make use of percentile rankings to determine what factors work. The data shown in this week’s chart, for instance, shows the long-term returns of portfolios composed of stocks from different valuation quintiles. The stocks in each of the chart’s quintiles are grouped based on their relative price-earnings ratios. (Technically, French inverts the ratio to earnings to price, but the results are the same: Cheap outperforms expensive.)

There are two advantages to relative valuations. The first is that they allow you to make comparisons across many stocks. This is helpful when you are trying to identify how attractive a stock is given the prevailing market conditions.

Secondly, relative valuations make it easier to find both potential investments and ones to avoid. There will always be stocks whose price-earnings ratios rank in the cheapest 20% and stocks whose price-earnings ratios rank in the priciest 20%, regardless of what their absolute price-earnings ratios are.

With this in mind, here is an updated look at the average valuation ratios underlying our A+ Investor Value Grade. (All data is from AAII’s Stock Investor Pro and LSEG Data & Analytics as of September 20, 2024.)

Price to Sales

The price-to-sales (P/S) ratio is determined by dividing market price per share by the sales per share for the most recent 12 months. Seeking undervalued stocks based upon the price-to-sales ratio was first popularized by Kenneth Fisher in his book “Super Stocks” (McGraw-Hill, 1984).

Proponents of the price-to-sales ratio argue that earnings-based approaches to selecting stocks are inferior because earnings are influenced by many management assumptions trickling through the accounting books. The price-to-sales ratio can provide a meaningful valuation tool when negative earnings render earnings-based models useless.

While price-to-sales ratios of below 1.0 have traditionally been viewed as indicating cheaply valued stocks, most stocks currently trade with ratios above 1.0.

Price to Earnings

The price-earnings ratio, or earnings multiple, is one of the most popular measures of company value. It is computed by dividing the current stock price by earnings per share for the most recent four quarters.

The price-earnings ratio is followed by so many because it relates the market’s expectation of future company performance—embedded in the price component of the equation—to the company’s recent earnings performance. The greater the expectation for future growth, the higher the multiple of current earnings investors are willing to pay. However, there is no guarantee that these expectations will be met, making stocks with high price-earnings ratios risky.

While the price-earnings ratio for the market-capitalization-weighted S&P 500 index is high (28.4), there are still many companies trading with price-earnings ratios of under 20.0.

Enterprise Value to EBITDA

The ratio of enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) is determined by dividing enterprise value for the most recent quarter by EBITDA for the most recent 12 months. Enterprise value is a company’s market value of equity (including preferred stock) plus its interest-bearing debt minus excess cash.

Some investors feel that a company’s enterprise value relative to its EBITDA is a better way to measure company value than the price-earnings ratio alone. The ratio is neutral to the company’s capital structure and capital expenditures (capex). EBITDA is an approximation of cash flow but is not actual cash flow.

Shareholder Yield

A stock’s shareholder yield—the sum of its buyback yield and dividend yield—shows the percentage of total cash a company is paying out to its shareholders, either in the form of a cash dividend or as expended cash to repurchase its shares in the open market. Thus, if a company is paying a 2% dividend yield and has a 3% buyback yield, its shareholder yield would be 5%.

Unlike other valuation measures, shareholder yield is inversely related to value, with higher shareholder yields implying lower valuations. A negative shareholder yield occurs when the percentage increase in the number of shares outstanding is greater than the stock’s dividend yield.

Price to Book Value

The price-to-book ratio is calculated by dividing the share price by book value per share. Book value is generally determined by subtracting total liabilities from total assets. It represents the value of the shareholder’s equity based upon historical accounting decisions.

The price-to-book ratio was a favorite measure of Benjamin Graham and his disciples who sought companies with a share price below the book value per share.

Small companies have been trading at historically low price-to-book ratios relative to large companies over the past few years. Because there are more small exchange-traded companies than large ones, the lowest quintile and median price-to-book values are both much lower than the highest quintile.

Price to Free Cash Flow

The price-to-free-cash-flow (P/FCF) ratio is calculated by dividing the share price by free cash flow per share for the most recent 12 months. Cash flow is reported on the cash flow statement. It is the sum of cash from operations, cash from investing and cash from financing adjusted for exchange rate effects. Free cash flow is calculated by subtracting capex and dividend payments from cash flow from operations.

The cash flow statement is harder to manipulate through accounting techniques than earnings. Unlike earnings, which are an accounting figure, cash flow represents the net total of cash flowing into and out of the company over a given period.

The higher the ratio, the more free cash investors expect a company to generate in the future—and the more potential downside.