Valuation Ratios That Matter

Track 6. Requires statement literacy from Financial Statements for Traders. Pairs with risk from Risk 101 and portfolio context from correlation risk. Price process: Intro to TA, structure. Hub: stock courses.

A Multiple Is a Story, Not a Button

Valuation ratios compress a messy business into a single comparison number: price versus earnings, enterprise value versus cash earnings power, free cash flow versus market cap. Traders misuse them in two opposite ways — treating a low P/E as a buy signal, or ignoring multiples entirely because “the chart is the only truth.” Both are incomplete. Multiples are relative pricing language the market uses to re-rate growth, margins, and risk. They do not time entries. They do not replace structure from S/R or event risk from gaps. Used well, they tell you whether the market is paying a rich or cheap claim on the cash and earnings streams you learned to read in Course 51 — and where that claim usually breaks.

This course covers the ratios that matter for equity traders and swing investors: P/E and forward P/E, PEG, EV/EBITDA, P/B where relevant, and FCF yield — with definitions, worked numbers, peer/context rules, and classic traps. For position risk while you learn, keep the risk calculator and percentage change calculator beside any “cheap” screen result.

1. What a Valuation Ratio Is Doing

Every common multiple has the form Price-like claim ÷ Fundamental claim (or the inverse yield form Fundamental ÷ Price). The market cap version uses equity value; enterprise-value versions adjust for net debt so capital structure is more comparable across firms. A “cheap” multiple means the market is paying less per unit of that fundamental — which can mean opportunity, or can mean the fundamental is about to collapse, the accounting is soft, or the business is permanently lower quality.

Trader uses (realistic):

• Context for re-ratings: growth stocks expand multiples on good guidance; mean-reversion fades extreme expansions when narrative breaks.
• Peer relative value: same industry, similar growth — large multiple gaps demand an explanation.
• Screen filters: not buy signals alone; inputs to a watchlist with structure and risk rules.
• Avoidance: “value trap” patterns — low P/E with falling FCF and rising debt.

They are not: a substitute for reading the income statement and cash flow (Course 51), a timing system, or comparable across unrelated sectors without adjustment (software vs banks vs REITs use different primary metrics). When in doubt, write the formula and the data vintage (trailing twelve months, next fiscal year, last quarter annualized) before you trust a vendor screen number.

2. P/E — Price to Earnings

Trailing P/E ≈ Market price per share ÷ EPS (last twelve months), or Market cap ÷ Net income to common (same idea). Forward P/E uses estimated next-twelve-months or next-fiscal-year EPS. Earnings yield = EPS ÷ Price (inverse of P/E) — useful when comparing to bond yields in macro regimes (later Course 58).

Worked example. Stock $50. LTM diluted EPS $2.50 → trailing P/E = 50 / 2.50 = 20×. Consensus NTM EPS $3.00 → forward P/E = 50 / 3.00 ≈ 16.7×. If peers with similar growth trade at 22× forward, this name is cheaper on that lens — unless estimates are aggressive, margins are peaking, or share count will dilute. Always check diluted shares and whether EPS is GAAP or “adjusted.”

Traps:

• Cyclical peak earnings: low P/E at the top of the cycle (commodity, deep cyclicals) is often a value trap.
• One-time gains: inflated EPS shrinks P/E for a quarter; cash did not improve sustainably.
• Loss-making growth: P/E is undefined or meaningless; use EV/Sales or path-to-profit frameworks instead.
• Accounting noise: stock-based compensation, write-downs, tax items — reconcile to cash (Course 51).
• Different fiscal years / estimate vintages: “forward” is only as good as the consensus quality.

For traders, a sudden multiple expansion with no earnings change is pure sentiment/narrative — trade the structure, not the story, and size with ATR / Risk 101. A multiple compression after a beat can still be a short if estimates reset lower next quarter. Always separate earnings-driven moves from pure re-rating moves in the journal so you know what edge you thought you had.

3. PEG — Growth-Adjusted P/E (Handle With Care)

PEG ≈ (P/E) ÷ (expected earnings growth rate in percent). Rule-of-thumb folklore: PEG near 1 is “fair,” below 1 “cheap,” above 1 “expensive.” That folklore is rough at best. Growth rates are estimates; P/E definitions vary; and a 40% growth rate for two years is not the same as 40% forever.

Worked example. Forward P/E 25×, expected EPS growth 20% → PEG = 25 / 20 = 1.25. Another name: P/E 15×, growth 8% → PEG = 1.875 — “cheaper” P/E can be “richer” PEG if growth is anemic. Conversely, PEG can make hypergrowth look cheap when the growth rate is fantasy.

Traps: using multi-year growth that will mean-revert; ignoring that high growth often needs high reinvestment (FCF may be weak); comparing PEG across sectors with different accounting; treating PEG < 1 as automatic long. Use PEG as a conversation starter about whether the multiple pays a sensible claim on growth — then verify growth quality on the statements.

4. Enterprise Value and EV/EBITDA

Enterprise value (EV) ≈ Equity market cap + interest-bearing debt + preferred + minority interest − cash & equivalents (definitions vary slightly; be consistent). EV asks what it would cost, in rough economic terms, to buy the operating business free of cash and taking on the debt.

EBITDA ≈ Operating earnings before interest, taxes, depreciation, and amortization — a crude proxy for operating cash generation before capex and working capital. EV/EBITDA compares whole-firm value to that proxy, making capital structure differences less distorting than raw P/E when leverage differs across peers.

Worked example. Market cap $8.0b. Net debt $2.0b → EV ≈ $10.0b. EBITDA $1.0b → EV/EBITDA = 10×. Peer median 12×. Appears cheaper — unless capex is massive (EBITDA overstates free cash), leases are large and excluded inconsistently, or EBITDA is inflated by non-recurring items.

Traps: EBITDA is not cash; capital-intensive businesses can look cheap on EV/EBITDA and starve on FCF; financials and some REITs need different primary metrics; acquisitive roll-ups with aggressive add-backs; ignoring pensions and other debt-like claims. Pair EV/EBITDA with FCF conversion and net leverage (net debt / EBITDA) from the balance sheet skill in Course 51.

5. Price to Book (P/B) — When It Helps

P/B ≈ Price ÷ Book value per share (equity on the balance sheet ÷ shares). Useful primarily for financials, asset-heavy businesses, and deep value screens where book is a meaningful economic anchor. Less useful for asset-light software where book understates intangible franchise value and is distorted by buybacks and R&D accounting.

Related: ROE (return on equity) × P/B relationships in simple models; tangible book adjustments when intangibles dominate. Traps: book can be stale or inflated (goodwill); banks need regulatory capital and credit quality, not headline P/B alone; negative equity breaks the ratio.

6. Free Cash Flow Yield — The Cash Claim

FCF yield ≈ Free cash flow ÷ Market cap (equity FCF yield), or FCF ÷ EV (firm-level). Using Course 51’s FCF ≈ CFO − capex (define consistently), a 5% FCF yield means roughly $5 of annual free cash per $100 of equity value — before arguing about growth and reinvestment.

Worked example. Market cap $5.0b. FCF $250m → FCF yield = 250 / 5000 = 5.0%. If the 10-year yield environment is ~4% and the business is stable, 5% may look reasonable; if the business is declining, 5% can still be a value trap. If growth FCF is depressed by heavy growth capex that will later harvest, yield can look low while the reinvestment is rational — read the investing section of the cash flow statement.

Many professional processes trust FCF yield more than P/E when earnings quality is questionable. For dividend-focused books (Course 54), FCF must cover distributions; yield screens that ignore payout vs FCF are incomplete.

Translate multi-year FCF growth and price moves with the percentage change calculator; journal outcomes with the P&L calculator and win rate calculator so “cheap” screens do not become unmeasured hope.

7. How Professionals Compare Multiples

1. Same industry first. Cross-sector P/E rankings are mostly noise.
2. Match growth and margin profiles. A 30× grower vs 12× no-growth peer is not an automatic short of the 30×.
3. Use the same definition. Trailing vs forward; GAAP vs adjusted; EV construction.
4. Check cycle position. Peak margins inflate earnings and shrink multiples deceptively.
5. Check leverage and liquidity. Cheap equity can be expensive firm value (or distressed).
6. Check cash conversion. Multiple vs FCF, not only vs EPS.
7. Then look at the tape. Structure, RS, and multi-timeframe bias (MTF, RS) decide timing.

A practical swing workflow: statements pass (Course 51) → multiple vs peers and history → catalyst calendar → chart invalidation → size dollars of risk (risk calculator, Kelly only on large samples). Never invert the order so a “cheap” print overrides risk limits from advanced risk frameworks.

8. Ratio Choice by Business Type (Quick Map)

9. Common Mistakes

• Buying lowest P/E in a broken industry without a catalyst or cash check.
• Shorting highest P/E growth solely because “it looks expensive” into momentum (trend can persist).
• Mixing trailing and forward multiples in a peer table.
• Ignoring dilution and buybacks when EPS drives the story.
• Trusting screening data vendors without sampling 10-Q reality.
• Position sizing on conviction from a multiple instead of dollars to invalidation.
• Forgetting that macro rate shocks re-rate long-duration growth multiples even when company numbers are fine.

10. Pre-Trade Valuation Checklist

1. Business one-liner and sector-appropriate primary multiple chosen.
2. Trailing and forward P/E (if profitable) with EPS definition noted.
3. EV/EBITDA or EV/Sales when leverage or losses make P/E weak.
4. FCF yield and FCF vs net income quality check.
5. Peer set (3–8 names) on the same definitions.
6. Cycle note: peak, trough, or mid — and margin sustainability.
7. Catalyst that could re-rate or de-rate the multiple.
8. Chart invalidation and $ risk sized (SL/TP, risk tools).
9. If holding through earnings: gap plan from Course 27.
10. Journal: “cheap/expensive because ___ ; wrong if ___.”

Tools for This Course

• Percentage Change Calculator — earnings growth, multiple expansion, and price moves.
• Risk Calculator · P&L · SL/TP — cheap is not a position size.
• Break-Even · Win Rate · Kelly — measure whether valuation-aware trades actually pay.
• Stock Courses Hub · prior: Financial Statements.