Equity Valuation Ratios Explained: How to Tell If a Stock Is Cheap or Expensive

I've had too many conversations where someone tells me they bought a stock because it "looks cheap." When I ask what they mean, they say the share price dropped 30%. That's not valuation — that's just a lower price tag on something that might still be overpriced.

Valuation ratios exist so you have an objective framework for deciding whether a stock is actually cheap or expensive relative to what the business earns, owns, or sells. Let me walk you through the most useful ones, with real examples from Indian markets.

First: Where Does Equity Return Come From?

Before we talk about ratios, understand this. When you own equity in a company — say, Infosys or Reliance — your return comes from two sources:

1. Capital appreciation: The stock price goes up as the business grows and earns more.
2. Dividends: The company distributes a portion of its profits to shareholders.

How much of the profit gets paid as dividends is called the dividend payout ratio. If TCS earns ₹100 per share and pays ₹45 as dividend, the payout ratio is 45%. The remaining 55% is retained in the business and ideally reinvested to grow earnings further.

Growth companies tend to have low payout ratios — they'd rather reinvest than distribute. Mature, stable companies (like PSU banks or established FMCG players) tend to pay out more.

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P/E Ratio: The Most Common (and Most Misused) Metric

Price-to-Earnings (P/E) = Current Stock Price ÷ Earnings Per Share (EPS)

If Infosys trades at ₹1,800 and its EPS is ₹60, the P/E is 30. You're paying ₹30 for every rupee of annual earnings.

Trailing vs Forward P/E

• Trailing P/E uses the last 12 months of actual earnings. This is based on real data, not estimates.
• Forward P/E uses the next 12 months of projected earnings. More useful if earnings are growing fast, but depends heavily on analyst accuracy.

In practice, both matter. A stock with a trailing P/E of 40 but forward P/E of 25 suggests analysts expect strong earnings growth — which may or may not happen.

How to use P/E

Don't look at P/E in isolation. Compare it against:

• The company's own historical P/E range
• The sector average
• The broader index (Nifty 50 typically trades between 20–25x in normal markets)

A P/E of 35 might be cheap for a company growing earnings at 30% per year. The same P/E would be absurd for a slow-growing PSU that earns predictably but has no real growth runway.

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P/B Ratio: What You're Paying for the Balance Sheet

Price-to-Book (P/B) = Market Price ÷ Book Value Per Share

Book value is basically the accounting net worth of the company — assets minus liabilities, divided by shares outstanding. If a bank's book value per share is ₹300 and it trades at ₹600, the P/B is 2x.

P/B is especially relevant for banks and financial companies because their assets (loans) and liabilities (deposits) are the core of the business. A bank trading at 1x book is roughly at fair value. HDFC Bank has historically commanded 3–4x book because of its strong profitability (high ROE) and consistency.

For asset-light businesses like IT services, P/B is less meaningful — the "assets" are mostly people, not equipment or inventory.

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Price-to-Sales (P/S): Useful When Profits Are Absent or Erratic

Price-to-Sales = Market Cap ÷ Annual Revenue

Sometimes companies are early-stage, loss-making, or have temporarily depressed margins due to expansion. In these cases, P/E doesn't work because there are no meaningful earnings.

P/S tells you how much you're paying for each rupee of revenue. Indian new-age companies like Zomato or Nykaa were valued on P/S ratios during their IPO phases because they weren't profitable.

The catch: revenue alone doesn't tell you whether the business makes money. A company can have fantastic revenues and still destroy value if its costs are out of control. So use P/S alongside margin trends and compare to sector peers.

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PEG Ratio: Fixing P/E's Biggest Blind Spot

PEG Ratio = P/E ÷ Earnings Growth Rate (%)

A company with a P/E of 30 growing earnings at 30% per year has a PEG of 1.0. A company with a P/E of 30 growing at just 5% has a PEG of 6.0. Same P/E, very different story.

Rule of thumb:

• PEG < 1 → potentially undervalued
• PEG = 1 → fairly valued relative to growth
• PEG > 1 → you're paying a premium for expected growth

The limitation is that PEG relies on growth rate estimates, which can be wrong. Use 3–5 year expected EPS CAGR for more stability than single-year projections.

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Dividend Discount Model (DDM): Valuing a Stock by Its Dividends

The DDM says a stock is worth the present value of all its future dividends. The simplified version (Gordon Growth Model) is:

Intrinsic Value = Dividend Per Share ÷ (Required Return − Dividend Growth Rate)

Example: If Coal India pays ₹25 as annual dividend, you require a 10% return, and dividends grow at 4% per year: Intrinsic Value = 25 ÷ (0.10 − 0.04) = 25 ÷ 0.06 = ₹417

If Coal India is trading at ₹350, it looks undervalued by this measure.

The DDM is most reliable for mature, dividend-paying companies with stable payout histories — utilities, PSUs, established FMCG. It breaks down for growth companies that pay little or no dividend.

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How to Actually Use These Ratios in Practice

Here's the honest version: no single ratio gives you the full picture. Use them together.

Step 1: Check if the business is fundamentally sound. Revenue growing? Margins stable or improving? Debt manageable? If the fundamentals are shaky, no valuation metric matters.

Step 2: Compare P/E and P/B to historical averages and sector peers. Is Reliance's P/E of 28 high? Compare it to its own 5-year average and to other energy/conglomerate peers. Context is everything.

Step 3: Layer in the PEG ratio. A high P/E with strong growth is fine. A high P/E with mediocre growth is a red flag.

Step 4: For dividend-paying stocks, run the DDM. It gives you a sanity check on intrinsic value that's separate from market sentiment.

Step 5: Watch for value traps. A low P/E stock is not automatically cheap. Sometimes it's cheap for a reason — declining business, regulatory risk, management issues. Dig deeper before buying.

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Quick Reference Table

Valuation is ultimately a judgment call informed by data. These ratios reduce guesswork, but they don't eliminate it. What they do is give you a framework so you're not just reacting to price movements and calling it analysis.