P/E and valuation
Is a stock cheap or expensive? The P/E ratio tells you how much you pay for each dollar of profit.
What's the whole company worth?
Sunny Slice's price is $30 a share, and it has 1,000,000 shares.
$30 × 1,000,000 = $30 million.
That's its : the price tag on the whole company. Is $30 million a lot for a pizza chain? It depends on how much money it makes.
The P/E ratio
The most popular quick check is the , price divided by earnings per share:
$30 ÷ $1.50 = 20.
You can do it for the whole company too: $30 million ÷ $1.5 million of profit = 20. Same answer.
A P/E of 20 means you pay $20 for every $1 of yearly profit. Another way to see it: if profit stayed exactly the same and all of it came to you, it would take 20 years to earn back what you paid.
Lemonade example: your friend wants to sell you a stand that makes $100 a year. If she asks $500, that's a P/E of 5. If she asks $5,000, that's a P/E of 50. The second price only makes sense if the stand is about to grow a lot.
Compared to what?
A P/E by itself means little. You have to compare.
- Slow Steady Soup: P/E 10. Cheap, but it grows only 3% a year.
- Sunny Slice: P/E 20. In the middle, growing 15% a year.
- Rocket Robots: P/E 60. Expensive, because people believe its profit will grow a lot.
- Wobbly Waffles is losing money. With no earnings, there's no P/E. That doesn't make it cheap or expensive. You just can't use this tool on it.
Good things to compare with:
- Similar companies. Compare pizza with pizza, not pizza with robots.
- The company's own past. If Sunny Slice usually trades between 15 and 25, a P/E of 40 is unusual.
- The whole market. Over the last hundred years or so, the US stock market's P/E has averaged about 15 or 16. In recent years it has usually been above 20. That's history, not a rule.
Why growth changes everything
Rocket Robots has a P/E of 60. Now imagine its profit doubles every year for three years: 2 times, then 4 times, then 8 times today's profit. At today's price, the P/E on that future profit would be 60 ÷ 8 = 7.5. Suddenly it looks cheap!
That's the bet growth investors make. If the growth shows up, they win. If it doesn't, they paid 60 for a slow company, and the price can crash. Because the future matters so much, many people look at the , which uses next year's expected profit.
Cheap for a reason
A low P/E can be a trap. Maybe customers are leaving. Maybe profit is about to drop. A stock that looks cheap and keeps getting cheaper is called a .
Valuation is a guess
means figuring out what something is worth. Nobody knows the true value of a company for sure. P/E is a quick tool, like comparing the price per slice of two pizza deals. It tells you about the price. It doesn't tell you whether the pizza is any good.
Remember
- Market cap = price × number of shares. It's the price of the whole company.
- P/E = price ÷ earnings per share: the dollars you pay for $1 of yearly profit.
- Compare P/E with similar companies, the company's past and its growth.
- A low P/E isn't automatically cheap, and a high P/E isn't automatically expensive.
Check yourself
1. A stock costs $40 and its EPS is $2. What's the P/E?
2. A company has 1,000,000 shares at $30 each. What's its market cap?
3. A company is losing money. What's its P/E?
4. Why might investors pay a P/E of 60 for a company?
Next lesson: The balance sheet
Money Tree School is education, not financial advice. Examples use made-up or historical numbers to show how things work; they are not recommendations to buy or sell anything. Markets can lose money.