Arguably, the single most important skill investors can learn is how to value a stock. Without this ability, investors cannot independently determine whether a company's stock price is low or high relative to its performance and growth projections.
Why assign values to stocks?
Investors assign values to stocks to help them decide whether to buy them, but there are more than one way to value a stock.
On one end of the spectrum, active investors -- those who believe they can develop and execute investing strategies that outperform the broader market -- value stocks based on the belief that a stock's intrinsic value is wholly separate from its market price. Active investors calculate a series of metrics to estimate a stock's intrinsic value and then compare that value to the stock's current market price.
Passive investors subscribe to the efficient market hypothesis, which says that a stock's market price is always equal to its intrinsic value. Passive investors believe that all known information is already reflected in a stock's price, so its price accurately reflects its value. Most adherents to the efficient market hypothesis suggest simply investing in an index fund or exchange-traded fund (ETF), rather than trying to outsmart the market.
Using GAAP earnings vs. adjusted earnings to determine the P/E ratio
GAAP is shorthand for generally accepted accounting principles, and a company's GAAP earnings are those reported in compliance with these principles. A company's GAAP earnings are the amount of profit it generates on an unadjusted basis, meaning without regard for one-off or unusual events such as business unit purchases or tax incentives received. Most financial websites report P/E ratios that use GAAP-compliant earnings numbers.
Non-repeating events can cause significant swings in profits, which is why some investors prefer to calculate a company's P/E ratio using a per-share earnings figure adjusted for the financial effects of one-time events. Adjusted earnings numbers tend to produce more accurate P/E ratios.
Continuing with the above example, Walmart's P/E ratio of 48.15 was calculated using unadjusted (GAAP) earnings of $2.73. The company, in its latest quarterly earnings report, indicates its adjusted EPS for the same period was $2.64.
Using this adjusted EPS value, we can calculate Walmart's adjusted P/E ratio as 49.97 -- the result of dividing $131.93 by $2.64.
What's a good P/E ratio for a stock?
A P/E ratio that is good for one investor may not be enticing to another. P/E ratios can be viewed differently depending on an investor's objectives, which may be more value- or growth-oriented.
Value investors prefer low P/E ratios. A stock for which the valuation implied by the market is substantially below its intrinsic value is likely attractive to value investors.
Growth investors are more likely to buy a stock with a high P/E ratio based on the belief that the superior rate of earnings growth, if not the absolute value of the earnings themselves, justifies the high P/E ratio.
How investors can use variations of the P/E ratio
Investors, particularly growth-oriented ones, often use a company's current and past P/E ratios to calculate two other metrics:
- The forward-looking P/E ratio
- The price-to-earnings to growth (PEG) ratio.
The forward P/E ratio is simple to compute. Using the P/E ratio formula -- stock price divided by earnings per share -- the forward P/E ratio substitutes trailing-12-month EPS for the company's projected EPS for the next fiscal year. Projected EPS numbers are provided by financial analysts and, sometimes, by companies themselves.
The PEG ratio accounts for a company's earnings growth rate. It is calculated by dividing the company's P/E ratio by its expected earnings growth rate. While many investors use a company's projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections over shorter periods increases the reliability of the resulting PEG ratio.
A stock with a PEG ratio below 1.00 is considered exceptionally valuable due to its impressive projected growth rate. However, with any financial metric, it's important to see how a company compares to its peers.
Other valuation metrics
Several metrics can be used to estimate the value of a stock or a company, with some metrics more appropriate than others for certain types of companies.
Price/sales ratio
Along with the P/E ratio, the price/sales (P/S) ratio is another common metric for valuing stocks. The P/S ratio is equal to a company's market capitalization -- the total value of all outstanding shares -- divided by its annual revenue. Because the P/S ratio is based on revenue rather than earnings, it is widely used to evaluate public companies that do not have earnings because they are not yet profitable.
Stalwart companies with consistent earnings, such as Walmart, are rarely evaluated using the P/S ratio. Amazon (AMZN -1.40%) has a history of inconsistent earnings growth, so despite its massive size, the P/S ratio is a metric investors still prefer to use to evaluate the online retailer.
In May 2026, for example, Amazon's market cap was $2.85 trillion. Its fiscal year 2025 revenue was about $717 billion. Dividing $717 billion by $2.85 trillion yielded a P/S ratio of 3.97 for Amazon.
Investors who wish to compare P/S ratios should be careful to compare only companies with similar business models. Across industries, P/S ratios can vary widely because sales volumes differ. Companies in industries with low profit margins typically need to generate high sales volumes.
Price/book ratio
Another useful metric for valuing a stock or company is the price-to-book ratio. "Price" refers to the company's stock price, and "book" refers to its book value per share. A company's book value is equal to its assets minus its liabilities (asset and liability numbers are found on companies' balance sheet). A company's book value per share is simply equal to the company's book value divided by the number of outstanding shares.
A company's price-to-book ratio is only marginally useful for evaluating companies with asset-light business models, such as software tech companies. This metric is more relevant for evaluating asset-heavy businesses, such as banks and other financial institutions.
It's a (value) trap!
A stock can appear cheap, but because of deteriorating business conditions, it actually is not. These types of stocks are known as value traps. A value trap may take the form of a pharmaceutical company with a valuable patent that soon expires, a cyclical stock at the peak of the cycle, or a tech company whose once-innovative offering is being commoditized.
Related investing topics
Other relevant factors for valuing a stock
Aside from metrics like the P/E ratio, which are quantitatively computed, investors should consider a company's qualitative strengths and weaknesses when gauging a stock's value.
A company with a defensible economic moat is better able to compete with new market participants, while companies with large user bases benefit from network effects.
A company with a relative cost advantage is likely to be more profitable, and companies in industries with high switching costs can more easily retain customers. High-quality companies often have intangible assets, such as patents, regulatory approvals, and brand recognition, that have considerable value.
As Warren Buffett famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
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