Three strategies for determining a stock's worthiness:

In the midst of escalating tariffs, trade conflicts, and technological uncertainties, the S&P 500 has witnessed a significant drop of nearly 10% since the beginning of the year (up to April 23rd). Global stock markets have also endured heightened volatility, leaving some investors panicking, while others see this as an opportunity to purchase at bargain prices.

When the stock market experiences a steep decline, company shares may appear cheaper as their prices fall compared to, for instance, a month ago. However, evaluating a stock's true worth goes beyond just comparing its share price.

For investing in top stocks, simple calculations using several valuation tools can provide clarity about a company's worth relative to its performance and the broader market. According to Matt Britzman, senior equity analyst at wealth manager Hargreaves Lansdown, using these tools helps make the often daunting task of determining a stock's fair value more manageable.

Here are three essential measures every investor should know, recommended by Britzman:

1. Price-to-earnings (P/E) ratio

The P/E ratio is a widely utilized tool to assess a company's share price in comparison to its earnings. It reveals how much investors are willing to pay for £1 of a company's profit. Our separate article explains what is a P/E ratio in more detail.

With the P/E ratio, investors can determine whether a stock is undervalued or overvalued, and also compare the price of a stock with those of other companies in the same industry.

A lower P/E signifies a cheaper share, but it is essential to understand that 'cheap' does not always equate to good value and may reflect concerns about the company's earnings. Conversely, companies with high P/E ratios may appear expensive, but this could signal anticipated strong, growing earnings.

The P/E ratio can be calculated as follows:

PE ratio = share price / earnings per share (EPS)

For instance, if a company's share price is £20, and it earned £2 per share in the past year, the PE ratio would be:

PE ratio = 20 / 2 = 10

Investors are thus paying £10 for every £1 of earnings.

The P/E ratio's significance lies in:

A lower P/E might suggest a stock is undervalued or that its growth prospects are limited.
A higher P/E may indicate the stock is expensive, investors expect strong growth in the future, or that earnings are high-quality.

Hargreaves Lansdown prefers to utilize an adapted version that incorporates anticipated earnings, rather than past earnings-known as the forward P/E ratio.

2. Price-to-earnings growth (PEG) ratio

The PEG ratio is an extended version of the P/E ratio, taking into account a company's expected growth rate. A stock may seem expensive based on its P/E, but its growth prospects can sometimes justify the higher price.

The PEG ratio can be calculated as follows:

PEG ratio = PE ratio / earnings growth

If a company has a PE ratio of 20 but is predicted to grow its earnings by 10% yearly, its PEG ratio would be:

PEG ratio = 20 / 10 = 2

The purpose of the PEG ratio:

A PEG ratio below one usually signifies a good value, suggesting the stock is well-priced relative to its growth.
A PEG ratio above one may indicate the stock is overvalued relative to its growth rate.

The PEG ratio is particularly valuable for growth stocks, where high PE ratios are prevalent. Technology companies, for example, often trade at high PE levels, but their rapid growth can make them attractive investments when the PEG ratio is reasonable.

3. Price-to-book (PB) ratio

The PB ratio is another crucial measure that contrasts a company's market value to its 'book value,' which is essentially the net worth of its assets after liabilities. Finding the book value in a company's annual report will provide the necessary number. It is typically listed as equity, shareholders' funds, or net asset value (NAV).

With the book value in hand, you can calculate the PB ratio by dividing the share price by the book value per share, allowing you to gauge how cheap or expensive the company is. If the number you obtain (the P/B ratio) is less than one, it implies the company can be purchased at a lower cost than its assets are worth, making it cheap.

For a deeper understanding of the price/book ratio, see our dedicated article: what is price/book ratio.

The PB ratio can be calculated as follows:

PB ratio = share price / book value per share

If a company's book value per share is £10, and the share trades at £15, the PB ratio would be:

PB ratio = 15 / 10 = 1.5

The importance of the PB ratio:

A PB ratio below one might indicate the stock is undervalued, or investors are wary about its prospects.
A higher PB ratio could reflect strong market confidence in the company's future growth.

The PB ratio is particularly useful for industries like banking and manufacturing, where cash and physical assets like property and equipment have significant roles. However, for companies with intangible assets-like technology companies-the PB ratio might be less relevant.

By using these three measures (PE, PEG, and PB), investors have access to essential tools for simplifying complex financial data. By comparing these ratios across similar companies or sectors, investors can identify whether a stock provides value, growth potential, or stability.

Begin with the PE ratio for a quick understanding of value. Then, use the PEG ratio to consider growth prospects. Finally, check the PB ratio for asset-heavy businesses.

Remember, no single measure can convey the full story. To make more informed, confident investment decisions, it's crucial to compare a stock's ratios with:

The company's historical ratios to observe how its valuation has evolved over time (using a 10-year average, according to Hargreaves Lansdown). Historical financial information for a company can be found in its accounts, often available on its website for large, publicly listed companies. For smaller UK companies, try Companies House.
The average valuation of competitors or the market as a whole.

In the words of Britzman: "Investing is for the long term - typically five years or more. You should always consider these ratios alongside additional factors, such as the company's overall financial health, industry trends, and broader economic conditions." By incorporating these tools, investors will be better equipped to make well-informed, confident decisions.

Lastly, it's essential not to be led by emotions during market downturns. John Plassard, senior investment specialist at Mirabaud Group, emphasizes that upheavals are a regular part of the investment process:

"Historically, the US stock market has experienced a correction of 5% or more almost every year (94%), and double-digit declines are also common."

Moreover, Plassard adds, the S&P 500 has averaged a 10% return every year since 1928, despite an average intra-year drawdown of 16%. In nearly 60% of the years since 1928, the S&P 500 has ended the year with double-digit gains, but in almost half of those years, there has also been a double-digit correction along the way.

In light of this historical context, Plassard highlights that downturns are inherent in the stock market's long-term growth journey.

In the midst of market volatility, considering the Price-to-Earnings (P/E) ratio can help investors determine if a company's stock is undervalued or overvalued, offering insight into its true worth.
The Price-to-Earnings Growth (PEG) ratio, an extension of the P/E ratio, takes into account a company's expected growth rate. A lower PEG ratio (less than one) often signifies a good value, suggesting the stock is well-priced relative to its growth.
The Price-to-Book (PB) ratio, which contrasts a company's market value to its 'book value,' or net worth of assets after liabilities, can help investors gauge a company's value in asset-intensive industries like banking or manufacturing. A PB ratio below one might indicate the stock is undervalued, while a higher PB ratio could reflect strong market confidence in the company's future growth.