Valuation Basics

What you will learn

• Understand the concept of valuation and why price tags matter.
• Learn how to read the most common valuation metric: the P/E Ratio.
• Recognize why comparing completely different companies is dangerous.

Core concepts

Valuation is simply the process of figuring out what a company is worth. As we learned earlier, a great company is only a good investment if you buy it at a fair price.

To figure out if a stock is cheap or expensive, investors use "valuation ratios." The most famous one is the P/E Ratio (Price-to-Earnings Ratio).

The P/E ratio compares the company's current stock price to the profit (earnings) it makes per share.

• If a stock costs $100, and the company makes $5 of profit per share every year, the P/E ratio is 20 ($100 / $5).
• Think of it like buying a small business: If a local cafe makes $50,000 a year in profit, and the owner wants to sell it to you for $1,000,000, you are paying a P/E of 20. It will take you 20 years of those profits to earn your money back.

A low P/E ratio generally means the stock is "cheap," and a high P/E ratio means the stock is "expensive."

What valuation can and cannot tell you

It is tempting to look for companies with the lowest P/E ratios and buy them, assuming you are getting a bargain. But the stock market is rarely that simple.

A high P/E ratio (an "expensive" stock) often means the market expects the company to grow very fast in the future. A hot new software company might have a P/E of 50 because investors believe its profits will triple in the next few years.

A low P/E ratio (a "cheap" stock) often means the market thinks the company's best days are behind it. A dying retail chain might have a P/E of 5. It looks cheap, but if its profits keep shrinking every year, it is actually a terrible investment. This is known as a "Value Trap"—a stock that looks like a bargain but is actually just a dying business.

Furthermore, you can only compare P/E ratios of similar companies. Comparing the P/E of a fast-growing tech company to the P/E of a slow-growing utility company is like comparing the price of a sports car to a tractor. They do different jobs and have different expectations.

Valuation is a framing tool. It doesn't give you a final answer, but it forces you to ask: What kind of future is the market expecting from this company, and do I agree with them?

Common mistakes

• Buying a stock just because its P/E ratio is very low, ignoring that the business might be failing.
• Assuming a high P/E stock is a guaranteed bad investment, ignoring that it might be growing incredibly fast.
• Comparing the valuation of completely different types of businesses (like a bank and a software company).