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2 important stock valuation ratios you need to understand

For outsiders the world of investing seems a complex and strange place. That’s because what can be seen on the TV is shiny suits, cheesy grins and a bunch of middle-aged men and women running frantically around cramped spaces waving small pieces of paper.

Fortunately somewhere in space and time, analysts and advisors devised a number a simple valuation techniques to help us everyday investors better understand this seemingly complex process. It should be noted that these techniques cannot be solely relied upon. At best, they enable us to make inferences about valuation and form only a tiny piece of an investment case.

Let’s take a look at each of following figures used by investors with both Australia and New Zealand Banking Group (ASX: ANZ) and Commonwealth Bank of Australia (ASX: CBA) as examples.

1. Price-Earnings (P/E)

The price-earnings or price to earnings ratio tells us the price investors are willing to pay for a unit of the company’s profit (earnings). We simply divide the company’s most recent annual profit (or expected annual profit for a forward price-earnings ratio) by the number of shares. We then divide the share price into that figure. The higher the result, the more “expensive” the stock is.

For example, ANZ’s earnings per share were $2.15 in 2013 and its current price is $33.71 giving it a P/E ratio of 14.68. Commonwealth Bank has a price-earnings ratio of 16.32.

Many investors take P/E ratios too seriously but they should never be substituted for actually researching a company. P/E ratios can drop in a day or an hour as share prices fluctuate but it doesn’t mean the underlying company has become any better of an investment!

In our example Commonwealth Bank shares appear more “expensive” but it may be likely to grow earnings at a faster pace than ANZ, therefore lowering its P/E ratio in the long-run. Factoring in growth prospects affords us a clearer picture.

2. PEG Ratio

This ratio was popularised by legendary investor Peter Lynch. The price-earnings to growth ratio is calculated by taking the price-earnings ratio and dividing it by the forecast earnings per share growth. Essentially, it puts the P/E ratio in context by making it slightly forward looking.

For example, ANZ is expected to grow earnings per share by 16.3% between FY14 and FY15 (from 216 cents per share to 251 cents per share). That gives it a PEG ratio of 0.87. Commonwealth (remember it has a higher P/E ratio) is only expected to grow earnings per share by 11%, therefore its PEG ratio is 1.48.

A number less than 1 could mean the stock is currently undervalued. A number greater than 1 could mean it’s overvalued.

Foolish takeaway

Assessing a company’s growth prospects based on past performance and share price is subjective and fraught with risk. However, these two ratios are simple to use and provide a basic overview of a business’s prospects, enabling you to decide whether, or not, you think it may be worth continuing to research a particular company in more depth. If you want to learn more, click here for a step-by-step guide on how to invest in the Australian stock market.

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Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies. 

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