Price-to-Earnings (P/E Ratio): How many dollars you pay for each dollar of the company's annual earnings. A P/E of 15x means you are paying $15 for every $1 of annual earnings — equivalently, it would take 15 years to 'earn back' your investment at current earnings with no growth. Lower P/E = cheaper relative to current earnings. Higher P/E = market expects strong future growth, or the stock is overvalued.
P/E Ratio = Stock Price ÷ Earnings Per Share (EPS)
Price-to-Book (P/B Ratio): How many dollars you pay for each dollar of the company's net assets (book value = assets minus liabilities). A P/B below 1.0 means you are paying less than the accounting value of the business — often a signal of a distressed, cyclical, or capital-intensive business. High P/B ratios (10x, 20x, 30x+) are common in asset-light businesses like software and consumer brands, where the competitive advantage is not on the balance sheet.
| Metric | Formula | What It Measures | Limitation |
|---|---|---|---|
| P/E | Price ÷ EPS | Price per dollar of current earnings | Earnings can be manipulated; ignores growth |
| P/B | Price ÷ Book Value per Share | Price per dollar of net assets | Book value ignores intangibles; misleading for asset-light businesses |
| FCF Yield | FCF ÷ Market Cap (or FCF ÷ Enterprise Value for credit-aware view) | Cash returned per dollar invested | FCF can be distorted by capex cycles; the equity-only version understates risk for highly leveraged firms — pair with FCF/EV |
| PEG | P/E ÷ Annual EPS Growth % | P/E adjusted for growth rate | Growth estimates are unreliable; best for stable growers |
FCF Yield (equity) = FCF ÷ Market Cap × 100% | FCF Yield (firm) = FCF ÷ Enterprise Value × 100%
FCF Yield vs. Bond Yield: The FCF yield on a stock can be compared directly to the yield on a 10-year Treasury bond. If a stock yields 8% in free cash flow and 10-year Treasuries yield 4.5%, the stock offers roughly a 3.5% premium to the risk-free rate — your compensation for equity risk. When bond yields rise, the premium shrinks and stocks become relatively less attractive. This connection between stock valuations and interest rates is one of the most important drivers of market prices.
DCF preview — the full intrinsic value calculation: Phase 2 established the Time Value of Money principle (a dollar today is worth more than a dollar tomorrow). DCF applies that principle directly to a business. Estimate the free cash flow a company will generate each year, then discount each year's cash back to today using a required rate of return. The sum is the intrinsic value. The critical insight: tiny changes in the assumed growth rate produce enormous changes in intrinsic value. This is why DCF is powerful and dangerous — garbage assumptions in, garbage value out.
Intrinsic Value ≈ FCF × (1 + g)^1 / (1 + r)^1 + FCF × (1 + g)^2 / (1 + r)^2 + … (over N years)
You have now learned how to read the key price-to-value ratios that appear on any ticker page. Two natural next steps exist depending on where you want to go deeper: **DCF mechanics (intermediate path):** The valuation metrics in this module are shorthand for a fuller intrinsic-value calculation. **dcf-201** walks through how to build a discounted cash flow model from scratch — estimating future free cash flows, choosing a discount rate, and computing a terminal value. If you want to move from 'this stock looks cheap on P/E' to 'I believe the intrinsic value is $X per share,' start there. **Valuation foundations (val-1):** For a broader conceptual grounding in how analysts approach valuation across different business types — including why different industries use different primary metrics — **val-1** covers the valuation landscape before the DCF deep dive. Both paths build on exactly what you have learned here. The metrics in pfvi-15 are the vocabulary; dcf-201 and val-1 teach you how to construct the sentence.
Sit with the ideas.
Company A trades at a P/E of 10x. Company B trades at a P/E of 25x. Company A's earnings have been flat for 5 years. Company B's earnings have grown at 20% annually for 5 years and are expected to continue. Which is the better value?