Fundamental Ratios & Screening Logic

Module 2.2: Fundamental Ratios & Screening Logic

Lesson 2.2.1: Valuation Ratios-P/E, P/B, P/S, and When to Use Each

Price-to-Earnings Ratio (P/E) is the most-quoted metric. It answers: "How many dollars are you paying for every dollar of annual earnings?"

Formula: P/E = Stock Price / Earnings Per Share

If Apple trades at $245 and earned $6.05 per share (LTM), P/E = 245 / 6.05 ≈ 40.5x.

Interpretation:

• P/E 10: You pay $10 for every $1 of earnings. Cheap (often means low growth or distressed).

• P/E 20: You pay $20 for $1 of earnings. Fair (S&P 500 average is ~20).

• P/E 40+: You pay $40 for $1 of earnings. Expensive (often means high growth or hype).

Trailing vs. Forward P/E: Trailing is based on the last 12 months of actual earnings. Forward is based on analyst estimates for the next 12 months. If a company is growing fast, forward P/E < trailing P/E. If slowing, forward > trailing.

Apple Example (January 2025):

• Trailing earnings: $6.05 per share (actual, last 12 months)

• Forward earnings (estimates): $6.35 per share (next 12 months, ~5% growth)

• Trailing P/E: 40.5x

• Forward P/E: 39x

The drop reflects analyst expectations of no acceleration.

Pitfalls:

• One-time charges: If a company took a $500M restructuring charge, earnings are depressed, P/E looks cheap artificially. Adjust for it.

• Cyclical industries: A mining company with record earnings due to commodity spike has a low P/E because earnings will fall. Use normalized earnings.

• Loss-making companies: P/E is undefined (or negative). Use Price/Sales instead.

P/E is a Starting Point, Not a Verdict A P/E of 15 looks cheap until you discover the company is losing market share to competition. A P/E of 50 looks expensive until you discover it's a 30% ROIC compounder. Ratio screening is the start; analysis is the grunt work.

Price-to-Book Ratio (P/B) compares price to equity value (book value).

Formula: P/B = Market Capitalization / Shareholders' Equity (Book Value)

Alternatively: P/B = Stock Price / Book Value Per Share

If a company has $10B equity and $30B market cap, P/B = 3.0. You pay $3 for every $1 of accounting equity.

When to Use:

• Asset-heavy businesses (banks, insurance, manufacturing): Book value approximates real value because assets are tangible.

• Financial institutions: P/B is the gold standard. A bank with P/B 0.7 is trading below break-up value.

Pitfall: Intangibles (brand, patents, customer relationships) are not on the balance sheet. Apple's brand is worth $100B+ but doesn't appear as an asset. Apple's P/B is ~50x because nearly all value is intangible. Don't apply P/B to software or pharma companies; use P/E instead.

Real Example: JPMorgan Chase (January 2025). Market cap $550B, book value $250B, P/B = 2.2x. Is this cheap? Historically JPM trades at 1.2-1.5x P/B. At 2.2x, it's at the high end. If rates fall and loan demand falters, P/B could compress to 1.5x, causing a 30% stock decline.

Price-to-Sales Ratio (P/S) compares price to total revenue (top-line sales).

Formula: P/S = Market Cap / Total Revenue (last 12 months)

A company with $10B revenue and $100B market cap has P/S = 10.

When to Use:

• Loss-making companies: P/E is useless if EPS is negative. P/S works.

• Comparing unprofitable growth companies: Tesla's P/S tells you how much you pay per sales dollar, regardless of whether they're profitable.

• Harder to manipulate than earnings: Managers can massage earnings through accounting, but revenue is harder to fake.

Pitfall: Revenue ≠ profit. A company can have massive sales but zero profit (low margins). Tesla has ~$80B revenue and P/S ~8x. But it also has 30%+ net margins, so profitability is real. A furniture retailer with $80B revenue but 2% margins is burning capital. P/S alone hides this.

Sector Benchmarks (as of early 2025):

| Sector | Typical P/E | Typical P/B | Typical P/S |

| Tech | 25-50 | 10-50 | 5-20 |

| Financials | 12-15 | 1.0-1.5 | 2-3 |

| Healthcare | 20-30 | 3-5 | 3-8 |

| Energy | 8-12 | 1.0-1.5 | 1-2 |

| Utilities | 15-20 | 1.5-2.0 | 2-3 |

| Consumer Staples | 20-25 | 3-5 | 1-3 |

A utility with P/E 18 is expensive. A tech stock with P/E 18 is cheap.

Self-Practice: Find three stocks in ValueMarkers screener: one with P/E <12, one with P/B <1.5, one with P/S <2. Do these make intuitive sense? (E.g., is the low P/E stock a cheap value trap, or genuinely undervalued?)

Lesson 2.2.2: Enterprise Value and the Moat of EV/EBITDA

Market Cap is what you pay to own equity. It ignores debt.

Enterprise Value (EV) = Market Cap + Total Debt - Cash & Equivalents

EV is what you pay to own the entire business (equity + paying off debt).

Why EV Matters: If you want to acquire a company, you must:

1. Buy all shares (market cap)

2. Assume or pay off all debt (adds to cost)

3. But you get to keep cash and short-term investments (reduces cost)

Example: Company has:

• Market cap: $100M

• Debt: $30M

• Cash: $10M

• EV = $100M + $30M - $10M = $120M

To acquire this company, you pay $120M.

EV/EBITDA Ratio = Enterprise Value / EBITDA

EBITDA = Earnings Before Interest, Taxes, Depreciation, Amortization. It's operating profit before financing and non-cash charges.

Why EBITDA? Because companies with different debt levels (and thus different interest expense) or different asset structures (and thus different depreciation) are not directly comparable on P/E. EV/EBITDA removes these distortions.

Example Comparison:

• Company A: Market cap $1B, debt $200M, cash $50M, EBITDA $200M → EV = $1.15B, EV/EBITDA = 5.75x

• Company B: Market cap $1B, debt $50M, cash $100M, EBITDA $200M → EV = $950M, EV/EBITDA = 4.75x

Both have the same EBITDA, but Company A looks cheaper on P/E ($1B market cap). Yet on EV/EBITDA, Company B is cheaper because its debt load is lower. A value investor should prefer Company B (less leverage, lower cost of capital, more margin of safety).

Sector Norms (EV/EBITDA):

| Sector | Typical Range |

| Tech | 12-25x |

| Telecom | 6-8x |

| Energy | 6-10x |

| Industrials | 8-12x |

| Utilities | 10-15x |

A telecom with EV/EBITDA 8x is average. A software company with EV/EBITDA 8x is a bargain (typical is 20+).

Enterprise Value Controls for Capital Structure Two companies with identical operations but different debt levels appear different on P/E. EV/EBITDA normalizes for this, making cross-company comparisons more honest.

Real Example: In 2024, the semiconductor industry had:

• TSMC: EV/EBITDA ~18x (high growth, market leader, expensive)

• Samsung Electronics: EV/EBITDA ~8x (lower growth, more conservative valuation)

Both make chips. But TSMC's capacity is fully booked; Samsung has idle capacity. The valuation gap reflects real differences in growth and profitability. A value investor might prefer Samsung if they believe chip demand recovers.

Self-Practice: Look up two competitors in the same industry (e.g., McDonald's vs. Chipotle). Compare their:

(a) P/E ratios

(b) EV/EBITDA ratios

Which metric gives a clearer comparison? Why?

Lesson 2.2.3: Free Cash Flow Yield and Cash-Based Valuation

Free Cash Flow (FCF) = Operating Cash Flow - Capital Expenditures

FCF is the cash generated after maintaining/expanding the asset base. It's what's available to shareholders (or debt holders).

FCF Yield = FCF / Market Cap

If a company has FCF of $1B and market cap of $20B, FCF Yield = 5%.

Why FCF Matters More Than Earnings: Earnings can be inflated by:

• Aggressive revenue recognition

• Capitalization of expenses (claiming an expense as an asset)

• Change in reserves or provisions

Cash flow cannot be faked. If a company generates $1B cash, it's real.

Example: A software company with $100M GAAP net income but $200M non-cash stock option expense and $50M capex actually generated:

• Operating cash flow: $150M (net income + non-cash charges)

• FCF: $100M ($150M - $50M capex)

The FCF yield is more honest than earnings yield.

Dividend Sustainability: A company paying $50M dividend with $100M FCF is safe (payout ratio 50%). A company paying $80M dividend with $100M FCF is strained (80% payout). If FCF drops 20%, dividend is cut. ValueMarkers flags dividend stocks at risk.

Real Example: AT&T (Telecom).

• 2024 market cap: ~$200B

• FCF: ~$30B

• FCF yield: 15%

• Dividend: ~$2.70 per share, sustainable

AT&T is a mature, stable business with high cash generation. The 15% FCF yield is attractive for income investors. Compare to a growth stock:

• Nvidia (Semiconductor)

• 2024 market cap: ~$3.5T

• FCF: ~$70B

• FCF yield: 2%

Nvidia grows fast, consumes capital, has low FCF yield but huge price appreciation potential. Both are valid, different profiles.

FCF Yield is Your Actual Return If a company has 5% FCF yield and 2% growth, you're looking at a 7% unlevered return (before taxes). Compare this to bond yields (4%), stocks you're considering (3% FCF yield), and inflation (2-3%). This tells you whether an investment is attractive.

Self-Practice: Find a stock you own (or are considering). Calculate:

(a) Operating cash flow (last 12 months)

(b) Capital expenditures

(c) FCF = (a) - (b)

(d) FCF yield = FCF / market cap

(e) Is this yield attractive relative to Treasury yields and inflation?

Lesson 2.2.4: Profitability Metrics-Margins and Return on Capital

Gross Margin = (Revenue - Cost of Goods Sold) / Revenue

It measures how much profit you make on each sales dollar before operating expenses.

Net Margin = Net Income / Revenue

It measures how much flows to shareholders after all expenses.

Operating Margin = Operating Income / Revenue

It measures how much profit comes from operations before interest and taxes.

Margin Compression Warning: If a company's margins are falling, profitability is eroding. Netflix grew revenue 40% annually 2015-2020 but margins were ~15%. By 2024, revenue growth slowed to 15% but margins improved to 25%+. This is a sign of a maturing business that became more profitable.

Sector Norms (net margins):

| Sector | Typical Range |

| Luxury retail | 10-15% |

| Software | 20-40% |

| Groceries | 2-5% |

| Pharmaceuticals | 15-25% |

| Banks | 20-30% |

A grocery chain with 3% margin is normal. A bank with 3% margin is weak.

Return on Equity (ROE) = Net Income / Average Shareholders' Equity

It measures how many dollars of profit are generated for every dollar of equity capital.

If a company has $10B equity and earns $2B, ROE = 20%. High-ROE businesses (>15%) are generally more valuable than low-ROE (<8%).

Pitfall: High ROE can be artificially inflated by leverage. A financial company with $100B assets, $90B debt, and $10B equity:

• If it earns $1B, ROE = 10%

• If debt increases to $95B (equity falls to $5B), and it still earns $1B, ROE = 20%

The business didn't get better; it got more leveraged (riskier). Look at ROE alongside debt ratios.

Sustainable ROE = Competitive Advantage If a company has 20% ROE while peers average 8%, it has an economic moat-a durable competitive advantage. This allows reinvestment at high rates, compounding value over decades.

Real Example:

• Microsoft: 40%+ ROE (software moat, network effects, brand)

• Google: 20%+ ROE (search moat, advertising duopoly)

• Campbell Soup: 12% ROE (commoditized, no moat)

If you reinvest at these rates for 10 years:

• Microsoft at 40% ROE grows equity value 13x (4x earnings, 40% reinvestment)

• Campbell at 12% ROE grows 3.1x

This is why moat-y companies trade at higher multiples.

Return on Invested Capital (ROIC) = NOPAT / Invested Capital

NOPAT = Net Operating Profit After Tax (operating profit minus taxes, excluding interest)

Invested Capital = Total Assets - Current Liabilities (or Equity + Debt)

ROIC measures how efficiently the business deploys capital, agnostic of how it's financed (equity or debt).

ROIC vs. WACC: Companies with ROIC > Weighted Average Cost of Capital (WACC) create value. If a company has 15% ROIC and 8% WACC, it's creating 7% spread. This spread, compounded over time, is value creation.

Berkshire Hathaway historically has 15-20% ROIC on a 5-6% WACC. Value creation spread: 10%+. This is why Berkshire is so profitable.

Self-Practice: Find three companies:

1. One with high margins (>20% net margin)

2. One with low margins (<5%)

3. One with high ROE (>20%)

For each, explain: Is the high/low margin due to industry, or competitive advantage? Is the ROE sustainable?

Lesson 2.2.5: Safety Metrics-Debt Ratios, Coverage, Liquidity

Debt-to-Equity Ratio (D/E) = Total Debt / Shareholders' Equity

If a company has $100B debt and $50B equity, D/E = 2.0. It has $2 of debt for every $1 of equity.

Safe Ranges:

• D/E < 1.0: Conservative, lots of equity cushion. If assets fall 50%, equity still positive.

• D/E 1.0-2.0: Moderate. If assets fall 25-50%, equity impaired.

• D/E > 3.0: Aggressive. One bad year can wipe out equity.

Real Example: In 2008 financial crisis:

• Wells Fargo: D/E ~8x. They nearly failed; required TARP bailout.

• JP Morgan: D/E ~13x but fortress balance sheet, strong liquidity. Survived and bought failed competitors.

The same leverage hurt Wells Fargo but helped JPM because JPM's assets held value (strong loan portfolio). Always look at leverage alongside asset quality.

Leverage Amplifies Results 20% ROE with 1:1 leverage is fine. 20% ROE with 3:1 leverage is fragile. A 20% fall in assets wipes out a third of equity.

Interest Coverage Ratio = EBIT / Interest Expense

If a company has $100M EBIT and $25M interest expense, coverage = 4x. The company earns 4 times its interest expense, so debt is easily serviceable.

Safe Ranges:

• Coverage > 5x: Safe

• Coverage 2-5x: Moderate risk

• Coverage < 2x: High risk of distress

Current Ratio = Current Assets / Current Liabilities

If a company has $500M current assets and $250M current liabilities, current ratio = 2.0. It can cover short-term obligations twice over.

Safe Range: 1.5-2.0 for industrial companies. Below 1.0 means potential cash crunch.

Debt Trends: Look at debt trajectory over 3-5 years.

• Increasing debt + flat earnings = Deteriorating credit health

• Decreasing debt + growing earnings = Strengthening balance sheet

• Increasing debt + increasing earnings = May be OK if organic growth justifies it

Real Example: Amazon (2015-2025).

• 2015: $24B revenue, $1.8B net loss, $20B debt → Looked terrible

• 2025: $575B revenue, $40B+ operating profit, $106B debt → Debt is 2 years of operating profit, very manageable

Amazon got away with massive debt because it reinvested all earnings into growth. The debt-to-income ratio improved. A conventional value investor might have missed this, fearing Amazon's "high" debt.

Self-Practice: Compare a mature, profitable company (e.g., Coca-Cola) vs. a growing, lower-profit company (e.g., Shopify):

• Which has higher D/E?

• Which has higher interest coverage?

• Which is more risky? Why?

Lesson 2.2.6: Building Multi-Factor Screens and Validating Strategy

A single-factor screen (e.g., "P/E < 12") catches value traps. A cheap stock is cheap for a reason: deteriorating moat, balance sheet stress, or cyclical trough. Smart screening combines:

Value (35% weight on ValueMarkers VMCI):

• P/E < 15 (sector-adjusted)

• EV/EBITDA < 10x

• FCF yield > 5%

Quality (30% weight):

• ROE > 15%

• Net margin > 10%

• Debt-to-Equity < 2.0

Safety (15% weight):

• Interest coverage > 5x

• Current ratio > 1.5

• Revenue growth > 0% (not declining)

Growth (12% weight):

• EPS growth 3+ years > 5%

Risk (8% weight):

• Volatility (Beta) < 1.5

A stock passing all these criteria is rare (maybe 100-200 globally). These are your best opportunities.

Guru Screening Presets (on ValueMarkers):

1. Graham Defensive: P/E <15, Current Ratio >1.5, Debt/Equity <0.5. Targets: ultrasafe stocks for risk-averse investors.

2. Deep Value Net-Net: Price < (Current Assets - Total Liabilities). Targets: extreme discounts, typically distressed.

3. Buffett Quality: ROE >20%, Debt/Equity <1, P/E <20. Targets: quality moats at reasonable price.

4. ROIC Champions: ROIC >15%, WACC <8%. Targets: compounders.

5. Magic Formula (Greenblatt): Rank by (ROIC × 1-year earnings yield). Buy highest-ranked. Targets: blended value+quality.

Validating Your Screen: Backtesting (in ValueMarkers or Excel):

1. Run your screen as of Jan 1, 2020

2. Note the top 20 stocks

3. Check their returns through Jan 1, 2025

4. Repeat for multiple periods (2015-2020, 2020-2024)

5. Does your screen beat the S&P 500? By how much?

Real Example: Deep Value Net-Net screen (2008-2010):

• Screened thousands of stocks

• Found ~50 trading below cash-per-share

• Equal-weighted portfolio returned +80% over next 3 years (2010-2013)

• S&P 500 returned +55%

The screen worked because post-crisis, there were genuine 50-cent dollars. By 2015, such opportunities were rare. A screen must adapt to market regime.

Screening is a Starting Point, Not an Ending A screen narrows 7,000 stocks to 50. Then you do bottom-up analysis: competitive position, management quality, catalysts. Without analysis, you're still making emotional decisions.

Self-Practice: Build a multi-factor screen on ValueMarkers:

• (P/E < 15 AND ROE > 15%) OR (EV/EBITDA < 10 AND Debt/Equity < 1.5)

• Limit to global exchanges, exclude financials (which have different metrics)

• Note the top 20 results

• Deep-dive into the top 3: Are they genuine bargains, or traps?

Lesson 2.2.7: ValueMarkers' VMCI Scoring System and 120 Indicators

ValueMarkers computes a Composite Score (VMCI, 0-100) by:

1. Computing 120 indicators across 5 pillars (Value, Quality, Integrity, Growth, Risk)

2. Percentile-ranking each indicator against peer universe (0-100 scale)

3. Averaging within each pillar to get pillar scores

4. Weighting pillars (35% Value, 30% Quality, 15% Integrity, 12% Growth, 8% Risk)

5. Computing VMCI = weighted sum

Pillar Breakdown:

VALUE (35%): 28 indicators including P/E, P/B, P/S, EV/EBITDA, EV/FCF, FCF yield, Dividend Yield, Earnings Yield, PEG ratio, Graham Number, DCF vs. Market Price.

QUALITY (30%): 41 indicators including ROE, ROIC, Net/Gross/Operating Margins, Cash Flow/Earnings Ratio, ROIC-WACC spread, revenue growth consistency.

INTEGRITY (15%): 16 indicators including Debt/Equity, Current Ratio, Altman Z-Score, Piotroski F-Score, Beneish M-Score, cash flow quality.

GROWTH (12%): 15 indicators including EPS growth (1Y, 3Y, 5Y CAGR), revenue CAGR, dividend growth.

RISK (8%): 20 indicators including Beta, volatility, debt service ratio, capex intensity.

Interpretation:

• VMCI > 75: Top decile, high conviction buys

• VMCI 60-75: Good value, worth deeper analysis

• VMCI 40-60: Fair value, average opportunity

• VMCI < 40: Low ranking, either risky or overpriced

Free Tier Limitation: Free users see only 30 indicators (roughly half of each pillar). Analyst+ see all 120. This unlocks deeper analysis, especially in Integrity (many fraud flags unavailable to free).

Gamification Value Score (separate from VMCI): 0-100 scale, measures "bang for buck" for aggressive value investors.

• Price Test (40%): How cheap is the stock absolutely?

• Quality Test (40%): Is there genuine business quality?

• Safety Test (20%): Is the balance sheet solid?

Hard rule: If Beneish M-Score > -1.78 (fraud risk), Safety capped at 30, regardless of other factors. This prevents buying Enron-like companies.

Real Example: Looking up Tesla on ValueMarkers (Jan 2025):

• VMCI: 42 (below average, stock is expensive)

• Value pillar: 25 (very high valuation multiples)

• Quality pillar: 78 (strong margins, ROIC)

• Growth pillar: 35 (slowing growth vs. 2020-2021)

• Gamification Value Score: 28 (not a value bargain)

Conclusion: Tesla is a great business (quality 78) but priced for perfection (VMCI 42). Wait for a 30-40% correction or faster growth for a compelling value entry.

VMCI Combines Rigor and Simplicity Rather than cherry-picking 2-3 ratios, the 120-indicator framework captures business quality holistically. A stock with VMCI 70+ has passed a gauntlet of tests. These are your best odds.

Self-Practice: Using ValueMarkers, find:

1. A stock with VMCI > 75 (top decile)

2. A stock with VMCI 40-60 (fair value)

3. A stock with VMCI < 40 (low ranking)

For each, explain: What makes the high-VMCI stock attractive? Why is the low-VMCI stock cheap-genuine risk, or market mispricing?