How to Evaluate Stocks: Fundamental Analysis for Financial Advisors

The three valuation ratios most advisors learn first are the price-to-earnings ratio, the price-to-book ratio, and dividend yield. They appear on every fund fact sheet, every stock screener, and every wholesaler deck that crosses your desk. They are also the three metrics most likely to mislead when used in isolation, because each one answers a different question about a company’s value, and none of them answers the question clients actually care about: is this stock worth owning?

A company trading at 15 times earnings looks cheap next to one trading at 35 times earnings. But that comparison says nothing about earnings quality, growth trajectory, balance sheet strength, or whether those earnings are likely to persist through the next economic cycle. The advisor who stops at the P/E ratio is doing the same analysis a client could run in five minutes on any free screening tool. The advisor who understands where each metric works, where it fails, and how the metrics interact is doing something a screening tool cannot replicate.

This guide covers the core valuation framework that financial professionals use to evaluate individual stocks and, more importantly, to evaluate the equity funds that hold them. We start with each metric’s mechanics, move through the conditions under which each one breaks down, and finish with how these tools translate into the conversations advisors actually have with clients.

The Price-to-Earnings Ratio: What It Measures and What It Misses

The price-to-earnings (P/E) ratio divides a company’s stock price by its earnings per share. A stock trading at $100 with earnings of $5 per share has a P/E of 20, meaning investors are paying $20 for every $1 of current earnings.

Two versions appear in practice. Trailing P/E uses the most recent 12 months of reported earnings. Forward P/E uses analyst estimates for the next 12 months. Trailing P/E reflects what actually happened. Forward P/E reflects what the market expects to happen. The gap between them reveals how much of the current stock price is built on expectations rather than results.

To put current market context around these numbers: the S&P 500 traded at a trailing P/E near 30 and a forward P/E near 24 entering 2026. The historical median for the index is approximately 18. That gap between the current multiple and the long-term median is not necessarily a warning signal, but it does mean the market is pricing in earnings growth that has to materialize for valuations to make sense. If earnings grow as analysts project, forward P/E compresses naturally. If they disappoint, the math works against investors.

What the P/E Ratio Tells You

At its best, the P/E ratio provides a quick, comparable measure of how much the market is willing to pay for a company’s earnings power. A low P/E relative to peers may indicate a stock the market has overlooked or temporarily abandoned. A high P/E may reflect confidence in future growth that justifies a premium valuation.

Within equity fund analysis, aggregate P/E ratios distinguish growth portfolios from value portfolios. The Russell 1000 Growth Index carried a trailing P/E near 39 entering 2026, while the Russell 1000 Value Index traded near 22. That difference captures the fundamental tension between the two investment philosophies: growth investors pay premium prices for companies expanding rapidly; value investors seek companies whose current earnings are priced cheaply relative to what those earnings are worth.

Where the P/E Ratio Breaks Down

The P/E ratio’s most dangerous limitation is that earnings are not a fixed target. GAAP permits meaningful discretion in revenue recognition timing, depreciation schedules, inventory valuation methods, one-time charges, and stock-based compensation. Two companies with identical underlying economics can report materially different earnings per share depending on their accounting choices.

This matters most for companies reporting non-GAAP or “adjusted” earnings. A company with a GAAP P/E of 50 might report a non-GAAP P/E of 30 after backing out stock-based compensation and restructuring charges. Both numbers are technically accurate. Neither tells the full story. When evaluating stocks or funds using P/E, the first question is always: whose earnings definition am I using?

The P/E ratio also fails when earnings are negative. A company losing money has no meaningful P/E. Yet many early-stage growth companies and turnaround situations fall into this category. The metric simply cannot evaluate a meaningful portion of the publicly traded universe.

Cyclical companies present another problem. An oil company at the top of a commodity cycle may report record earnings and sport a very low P/E. That low P/E does not mean the stock is cheap. It may mean the market expects earnings to decline as the cycle turns. The reverse applies at cycle troughs: a high P/E during an earnings trough may indicate the market expects a recovery, not that the stock is expensive.

The Shiller Cyclically Adjusted P/E (CAPE) ratio attempts to solve the cyclicality problem by averaging inflation-adjusted earnings over 10 years. The CAPE stood near 40 entering 2026, well above its historical average near 17. CAPE provides longer-term valuation context, but its 10-year lookback can be distorted by a single extreme event like the 2008 financial crisis.

The Price-to-Book Ratio: Tangible Value and Its Limits

The price-to-book (P/B) ratio compares a company’s stock price to its book value per share, which is total assets minus total liabilities divided by shares outstanding. Where P/E measures what you pay for current earnings, P/B measures what you pay for a company’s net asset base.

A P/B below 1.0 means the market values the company at less than its accounting net worth. In theory, you could buy all the company’s stock, sell the assets, pay off the liabilities, and pocket the difference. In practice, a P/B below 1.0 more often signals that the market doubts whether the company’s assets are actually worth what the balance sheet claims.

The S&P 500’s price-to-book ratio stood near 5.65 entering 2026, roughly double the historical median near 2.9. Like the elevated P/E, this reflects a market dominated by asset-light companies whose value resides in intellectual property, brand strength, and network effects rather than physical plant and equipment.

What the P/B Ratio Tells You

P/B works best for evaluating companies with substantial tangible assets: banks, insurance companies, manufacturers, and real estate firms. For these companies, book value provides a meaningful floor. A bank trading at 0.8 times book value may be signaling that its loan portfolio has problems the market has identified. A bank trading at 1.8 times book value likely enjoys strong profitability relative to its capital base.

In the style box framework, the P/B ratio is one of the primary metrics that separates value funds from growth funds. Value portfolios carry lower P/B ratios because they favor companies trading near their asset values. Growth portfolios carry higher P/B ratios because they own companies whose market value far exceeds their tangible assets.

Where the P/B Ratio Breaks Down

The P/B ratio becomes unreliable for companies whose most valuable assets do not appear on the balance sheet. A software company’s code, a pharmaceutical company’s drug pipeline, a consumer brand’s reputation: none of these show up as balance sheet assets unless they were acquired through a purchase. A company that builds its brand internally reports no intangible asset. A company that buys an identical brand reports it at the acquisition price.

This asymmetry makes P/B comparisons across industries nearly meaningless. Even within the same industry, companies that have grown organically look different on a P/B basis from companies that have grown through acquisitions.

Share buybacks also distort book value. A company that aggressively repurchases its own stock reduces shareholders’ equity over time, pushing book value down and P/B up. The accounting identity is responding to capital allocation decisions that the P/B metric was never designed to capture.

Dividend Yield: Income, Discipline, and the Trap

Dividend yield measures the annual dividend per share divided by the stock price. A stock paying $3 per year in dividends at a price of $75 has a yield of 4%. Among the three core ratios, dividend yield is the only one that provides a direct measure of cash return to shareholders.

The S&P 500 dividend yield stood near 1.1% entering 2026, close to its historical low and well below the long-term median near 2.9%. This compressed yield reflects two forces: stock prices have risen faster than dividend growth, and a larger share of the index is now composed of technology and growth companies that pay minimal dividends or none at all.

What Dividend Yield Tells You

Dividends reveal something that earnings and book value cannot: actual cash flowing from the company to its shareholders. A company can report impressive earnings through accounting choices, but it cannot fake a dividend payment. Paying dividends requires real cash, which imposes a financial discipline that non-dividend companies can avoid.

Historically, dividends have contributed a substantial portion of total equity returns. For advisors building income-oriented portfolios, dividend yield identifies stocks and funds that prioritize shareholder distributions. Dividend-focused strategies range from high-yield approaches emphasizing current income to dividend growth approaches targeting companies with long histories of consecutive dividend increases. The S&P 500 Dividend Aristocrats Index, for example, requires at least 25 consecutive years of dividend increases for inclusion.

Where Dividend Yield Breaks Down

An unusually high dividend yield is often a warning, not a buying signal. When a stock’s price declines sharply, its yield rises mathematically even if the dividend itself has not changed. A company that traded at $100 paying a $4 dividend (4% yield) that falls to $50 now shows an 8% yield. The high yield reflects the market’s doubt that the dividend is sustainable, not a generous return waiting to be collected.

This “yield trap” catches investors who screen for the highest-yielding stocks without asking why the yield is elevated. Financial companies before the 2008 crisis offered yields well above the market average; those yields reflected risk the market was correctly pricing in.

Dividend yield also cannot evaluate companies that return capital through share buybacks rather than dividends. A technology company buying back $10 billion in stock annually may be returning more capital to shareholders than a utility paying a 5% dividend, but it shows a yield of zero. The metric measures one form of capital return and ignores the other.

Using Metrics as a System, Not a Checklist

Each of the three core ratios answers a distinct question. P/E asks: how much am I paying for this company’s current earning power? P/B asks: how much am I paying relative to the company’s asset base? Dividend yield asks: how much cash is the company returning to me right now? Used together, they paint a richer picture than any single metric provides.

A stock with a low P/E, a low P/B, and a high dividend yield is the textbook value candidate. But that combination also describes companies in structural decline: banks losing market share to fintech competitors, retailers being displaced by e-commerce, energy companies facing a long-term demand shift. The value trap looks identical to the value opportunity on a screener.

Conversely, a stock with a high P/E, a high P/B, and no dividend yield fits the growth profile. But that combination also describes speculative situations where the market has priced in a future that may never arrive. The difference between a justified premium and an unsustainable bubble is the quality and durability of the underlying earnings growth, and no ratio alone captures that.

What separates professional stock evaluation from casual screening is the willingness to dig beneath the ratios. Are earnings backed by cash flow, or driven by accruals? Is the company growing organically, or through acquisitions that inflate the top line while diluting returns? Can the balance sheet survive a downturn?

For advisors evaluating equity funds rather than individual stocks, these principles apply at the portfolio level. A fund’s weighted average P/E, P/B, and dividend yield reveal its investment philosophy. A large cap blend fund with a P/E of 20 and a 2% yield occupies different territory than a large cap growth fund with a P/E of 35 and a 0.5% yield. Understanding what those aggregate numbers mean helps advisors select complementary funds and explain portfolio positioning to clients.

Beyond the Big Three: Earnings Quality and Free Cash Flow

Professional stock analysis extends beyond the three headline ratios. Two additional measures address the most common failure point of the core metrics: earnings quality.

Free cash flow (FCF) measures the cash a company generates after funding its operations and capital expenditures. Unlike earnings per share, free cash flow is difficult to manipulate through accounting choices because it tracks actual cash movements rather than accrual-based income. A company with growing earnings but shrinking free cash flow is spending more to generate each dollar of profit. The price-to-free-cash-flow ratio provides a cleaner valuation picture than P/E for capital-intensive businesses because it accounts for the reinvestment necessary to maintain operations.

Earnings yield, the inverse of the P/E ratio, converts valuation into a format comparable to bond yields. A stock with a P/E of 20 has an earnings yield of 5%. Comparing that to the 10-year Treasury yield provides a rough gauge of whether stocks are priced attractively relative to bonds.

The Client Conversation: What Clients Actually Ask

Stock evaluation metrics become useful to advisors at the point where they translate into client conversations. Clients rarely ask about P/E ratios directly. They ask questions that these tools can answer.

“Is the market too expensive?” This is the most common version. A client has seen headlines about elevated valuations and wants reassurance or confirmation. The honest answer requires context. The S&P 500’s trailing P/E near 30 is above the historical median, but median P/E levels have trended upward over decades as the index’s composition has shifted toward asset-light, high-margin businesses. Comparing today’s P/E to the 1980s is comparing a technology-heavy index to an industrial-heavy index. The frame of reference matters as much as the number.

A more useful conversation acknowledges that valuations are elevated, explains that forward P/E near 24 reflects expected earnings growth, and helps the client understand what the market is pricing in and what would need to go wrong for that pricing to unravel.

“Should I own growth stocks or value stocks?” The temptation is to answer based on which style has performed better recently. Growth stocks outperformed value in eight of the last ten years, and the Russell 1000 Growth Index returned more than 21% in 2025 alone. But historical data across longer periods shows that value stocks have outperformed growth on a rolling 15-year basis the vast majority of the time. The honest answer is that style diversification reduces the risk of being wrong about which philosophy dominates the next cycle.

“Why is this stock so cheap?” When a client brings a stock with a low P/E or high dividend yield, the advisor’s job is to determine whether the price reflects a genuine opportunity or a value trap. That means looking beyond the ratios to the underlying business: Is revenue growing or shrinking? Are margins stable or compressing? Is the dividend covered by free cash flow, or is the company borrowing to maintain it? The ratios identify the question. The analysis answers it.

“My neighbor’s portfolio is up 40%. Why isn’t mine?” This conversation involves the consequences of valuation concentration. A pure growth portfolio can dramatically outperform in a bull market, but the same concentration that produces outsized gains also produces outsized losses. The advisor’s role is to explain that the portfolio was built to match the client’s actual risk capacity, not to chase the best possible outcome in any single year.

The Advisor’s Edge

The valuation data in this article is freely available. Any client with a brokerage account can look up P/E ratios, price-to-book values, and dividend yields for any stock or fund in seconds. What they cannot do is interpret those numbers in context: knowing when a low P/E signals opportunity versus decline, recognizing the conditions under which dividend yield becomes a trap rather than a reward, or understanding how a fund’s aggregate metrics reveal its positioning within a style cycle that may be about to turn.

These analytical skills separate a financial professional who advises clients from one who simply reports data. They develop through structured study and deliberate practice.

The Certified Fund Specialist® (CFS®) designation builds this analytical foundation across equity evaluation, fixed-income analysis, portfolio construction, and risk management. For advisors who want to move beyond screening tools and into the kind of analysis that clients cannot replicate on their own, IBF’s curriculum provides the framework.

For more on how growth and value investment styles have performed across market cycles and capitalization ranges, see Growth vs. Value Funds: Historical Returns and Current Positioning.

Sources and Notes: S&P 500 valuation data from S&P Global, Multpl.com, and GuruFocus. Russell 1000 Growth and Value index data from FTSE Russell and Siblis Research. Shiller CAPE data from Robert Shiller, Yale University. Dividend yield and historical medians from Multpl.com. Market cap classification conventions per Morningstar and FTSE Russell methodologies. This article is reviewed periodically and refreshed when significant market or methodological changes warrant an update.