Lesson 2: Valuation: Is This Stock Expensive or Cheap?
Objective
By the end of this lesson, you’ll be able to:
- Explain why a stock’s price tells you nothing on its own.
- Calculate and interpret the P/E ratio.
- Know when to use P/S and PEG instead.
- Avoid the two classic traps: “high P/E is always bad” and “low P/E is always a bargain.”
Introduction
The $900 Stock That’s Cheaper Than the $9 One
Here’s a question that trips up most beginners: Duck Co. trades at $900 a share and Goose Inc. trades at $9. Which one is more expensive?
Trick question. You can’t tell. A share price is like the price of one slice of pizza. It depends entirely on how many slices the pie was cut into. Valuation is about figuring out what you’re getting for your money, not what the slice costs.
Main Content
1. Price Is Not Value
Remember market cap from Unit 2? Share price × number of shares = what the whole company is worth on the market. Duck Co. at $900 with 1 million shares is a $900 million company. Goose Inc. at $9 with 1 billion shares is a $9 billion company. Goose is ten times bigger, even though its shares look “cheaper.”
To judge value, you compare the price to what the business produces. That’s what the ratios below do.
2. The P/E Ratio: Years of Earnings
Formula: Price per share ÷ earnings per share (EPS)
It tells you how many years of current earnings you’re paying for.
Example: Duck Co. trades at $40 and earned $2 per share last year. P/E = 40 ÷ 2 = 20. You’re paying 20 years of earnings for each share. If Goose Inc. trades at $9 with EPS of $0.30, its P/E is 30. Goose is the more expensive stock, despite the lower price.
3. What Counts as “Normal”?
There is no magic number. Compare two ways:
- To the industry. Utilities often trade at a P/E in the low teens. Fast-growing software companies can trade at 40 or more. Comparing a bank to a software company is comparing ducks to geese.
- To the company’s own history. If Duck Co. usually trades around a P/E of 15 and now sits at 35, something has changed: either the market expects faster growth, or the price got ahead of itself.
For a rough anchor, the S&P 500 as a whole has historically averaged a P/E somewhere in the mid-to-high teens, drifting higher in optimistic years.
4. P/S: For Companies With No Profit Yet
Young companies often lose money, so EPS is negative and P/E is meaningless.
Formula: Market cap ÷ annual revenue (or price per share ÷ revenue per share)
A P/S of 2 means you’re paying $2 for every $1 of yearly sales. It’s cruder than P/E, but it works for companies that are still growing into profitability.
5. PEG: P/E With Growth Included
A high P/E can be justified if earnings are growing fast. The PEG ratio adjusts for that.
Formula: P/E ÷ expected annual earnings growth rate (as a whole number)
Example: Duck Co. has a P/E of 20 and is growing earnings 20% a year. PEG = 20 ÷ 20 = 1. Goose Inc. has a P/E of 30 but grows only 10% a year. PEG = 3.
A PEG around 1 suggests the price is roughly in line with growth. Well above 1 means you’re paying a lot for that growth. Well below 1 can be a bargain, or a sign the growth estimate is too rosy.
6. The Two Traps
- “High P/E is always bad.” Not if the company is growing quickly and reliably. Some of the best long-term investments looked expensive the whole way up.
- “Low P/E is always a bargain.” Sometimes a stock is cheap because the business is shrinking, or carrying too much debt, or about to lose its biggest customer. Investors call this a value trap. Cheap and getting cheaper is not a deal.
7. What Ratios Can’t See
Ratios don’t measure a strong brand, a loyal customer base, great management, or a product nobody else can copy (investors call these advantages a moat). They’re a starting point for questions, not the answer. Use them alongside the earnings report from Lesson 1.
Activity: Same Industry, Different Price Tags
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Pick two companies in the same industry (two airlines, two retailers, two chipmakers).
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Look up each one’s P/E, P/S, and expected growth rate on a finance site. Most show them under “Statistics” or “Valuation.”
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Calculate a rough PEG for each.
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Write a sentence on which looks cheaper, and one possible reason the market prices them differently.
Reflection Question: Did the stock with the lower share price turn out to be the cheaper one by the ratios?
Summary
Share price alone tells you nothing. Valuation compares the price to what the business produces: earnings (P/E), sales (P/S), or earnings adjusted for growth (PEG). Always compare within an industry and against the company’s own history, and remember that cheap can be cheap for a reason.
Key Takeaways:
- P/E = price ÷ EPS. It’s the number of years of earnings you’re paying for.
- Use P/S when a company isn’t profitable yet, and PEG to account for growth.
- Compare like with like: same industry, and the company’s own past.
- High P/E isn’t automatically bad, and low P/E isn’t automatically a bargain. Watch for value traps.
Quiz Time!
Next Lesson
Lesson 3: Bonds and Cash: The Boring Part of Your Portfolio
Not every dollar wants a roller coaster. Next we cover bonds, high-yield savings, and Treasuries: what they are, why interest rates move them, and where the “cash” part of your portfolio should actually live.