What key financial ratios tell me if a stock is overvalued?
I've been learning about fundamental analysis and keep seeing terms like P/E ratio, PEG ratio, and price-to-book being thrown around. While I understand these are important for determining if a stock is overvalued, I'm not entirely sure how to come do definite conclusion.
I'm trying to build a long-term portfolio and want to make sure I'm not overpaying for stocks. Could someone explain which 2-3 key ratios I should really focus on as a beginner?
I appreciate your help! 🙏
1 Answer
Great question, I’d suggest starting with these 3 key ratios:
P/E Ratio (Price-to-Earnings) – This tells you how much you're paying for $1 of a company’s earnings. A high P/E might mean a stock is overvalued, but it can also mean investors expect strong future growth. Compare it to other companies in the same industry and with industry/sector average for context.
PEG Ratio (Price/Earnings to Growth) – This builds on the P/E ratio but adjusts for expected growth. A PEG around 1 is considered fair value. Below 1 could mean undervalued (if growth projections are realistic), and above 1 might mean overvalued.
Price-to-Book (P/B) Ratio – This compares the stock price to the company’s book value (essentially its net assets). It’s more useful for asset-heavy industries (like manufacturing). A P/B under 1 can mean the stock is undervalued — but again, always look at the bigger picture.
No single ratio tells the full story. Use them as tools to spot red flags or find bargains — but always consider the company's overall health, growth potential, and the industry it's in.