A stock being “cheap” and being “good” are different things. A stock with a low PER may look cheap, but the company’s earnings could be declining. A stock with a high ROE may look good, but it could already be overvalued. Evaluating a company properly requires looking at both valuation (cheap or expensive?) and quality (earns well or not?) together.

Valuation Indicators

Valuation indicators answer “is this stock cheap or expensive at its current price?” In general, lower means undervalued, higher means overvalued.

PER

PER (Price-to-Earnings Ratio) divides the stock price by earnings per share (EPS).

PER = Price / Earnings Per Share (EPS)

A PER of 10 means “assuming current earnings continue, it takes 10 years to recoup the investment.” It is intuitive and the most widely used valuation indicator.

A low PER suggests the stock is undervalued relative to its earnings. However, there are caveats.

Negative PER for loss-making companies. If earnings are negative, PER is also negative. A negative PER is meaningless as a comparison metric. PSR is typically used instead for loss-making companies.

Industry differences. IT companies often have average PERs of 20-30x, while banks and utilities typically range from 5-10x. Industries with high growth expectations reflect future earnings, resulting in higher PERs. The same PER carries different implications depending on the industry.

PBR

PBR (Price-to-Book Ratio) divides the stock price by book value per share (BPS).

PBR = Price / Book Value Per Share (BPS)

PBR evaluates the stock price relative to the company’s asset value. A PBR of 1 means the stock price equals net asset value. A PBR below 1 implies that even liquidating the company would yield more than the current stock price.

Benjamin Graham viewed low-PBR stocks as investments with a “margin of safety.” It remains a core value investing indicator. However, a low PBR is not always positive. When asset values are overstated (distressed assets, inadequate depreciation), a low PBR may not reflect genuine safety margin.

PSR

PSR (Price-to-Sales Ratio) divides the stock price by sales per share.

PSR = Price / Sales Per Share

PSR’s advantage is that it applies to loss-making companies. Revenue is almost always positive. It is useful for valuing early-stage growth companies that have not yet turned a profit.

A low PSR suggests the stock is undervalued relative to revenue. However, PSR does not reflect profit margins. If a company generates high revenue but no profit, PSR alone is insufficient for evaluation.

Quality Indicators

Quality indicators answer “does this company earn well, and is it financially safe?” Unlike valuation indicators, higher is generally better (except for debt ratio).

ROE

ROE (Return on Equity) divides net income by shareholders’ equity.

ROE = Net Income / Shareholders' Equity × 100%

It shows how much the company earned with the money shareholders invested. An ROE of 15% means the company generated 15 in net income for every 100 in equity.

Warren Buffett reportedly considers companies that consistently maintain ROE above 15% as high-quality businesses. Higher ROE indicates better profitability relative to shareholder capital.

However, a high ROE may result from debt leverage. If equity is low and debt is high, the denominator shrinks, inflating ROE. To distinguish this, examine ROA alongside ROE.

ROA

ROA (Return on Assets) divides net income by total assets.

ROA = Net Income / Total Assets × 100%

It shows how efficiently the company utilizes all assets (equity + debt).

Comparing ROE and ROA reveals the debt leverage effect. High ROE with low ROA indicates returns driven by borrowed money. High ROE with high ROA indicates genuine asset efficiency.

High ROE + High ROA → Efficient, high-quality company
High ROE + Low ROA  → Reliant on debt leverage
Low ROE             → Low profitability overall

Debt Ratio

The debt ratio divides total liabilities by shareholders’ equity.

Debt Ratio = Total Liabilities / Shareholders' Equity × 100%

Lower is safer. A debt ratio of 100% means liabilities equal equity. Above 200% is generally considered a warning sign.

Debt itself is not inherently bad. Appropriate leverage supports business expansion. The problem arises when debt becomes too large to service, or when economic downturns amplify repayment pressure. Quant strategies use debt ratio as a safety factor to filter out excessively leveraged stocks.

Combining the Two Axes

Viewing valuation and quality indicators together matters more than looking at each in isolation.

Low PER + High ROE. Cheap relative to earnings and highly profitable. This is the ideal combination for an undervalued quality stock. In practice, such opportunities rarely persist because the market reprices quickly.

Low PER + Low ROE. Cheap but poor earnings. “Cheap for a reason.” This is called a value trap. Relying on PER alone can lead to this pitfall.

High PER + High ROE. Expensive but highly profitable. This combination frequently appears in growth stocks. The question becomes whether the premium reflects genuine future growth or overvaluation.

A single indicator can mislead. Combining valuation and quality is the starting point of a multi-factor strategy.

Valuation indicators (PER, PBR, PSR) judge “is the stock cheap?” Quality indicators (ROE, ROA, debt ratio) judge “does the company earn well and is it safe?” Evaluating both axes together is essential for proper stock assessment.

The next post will cover momentum and dividend indicators — factors that look at market trends and cash flow rather than the company itself.

References