How Stocks Are Valued
Two companies can have wildly different stock prices — one at $30, another at $3,000 — and that tells you almost nothing about which one is the better investment, because price alone, without context, is close to meaningless. Learning what actually makes a stock "cheap" or "expensive" is what this lesson is about.
Price vs value
It's easy to confuse a stock's market price — whatever it's currently trading for on an exchange, set moment-to-moment by supply and demand (see Lesson 2.2) — with its intrinsic value — what the company is actually worth, based on its real underlying business: its assets, profits, growth prospects, and risks. These two numbers are related but not identical. Markets are generally good at pricing companies reasonably over the long run, but in the short run, prices can drift away from intrinsic value due to hype, panic, or simply incomplete information — which is exactly the gap that active stock analysts and investors are trying to spot and profit from. Warren Buffett has a famous version of this idea: "price is what you pay, value is what you get."
Earnings per share (EPS)
Before you can judge whether a stock's price is reasonable, you need a sense of how much money the company actually makes. Earnings per share (EPS) is a company's total profit divided by its total number of outstanding shares, showing how much profit is attributable to each individual share.
EPS gives you a per-share lens on profitability, but on its own it still doesn't tell you whether the stock's price is a good deal — a $5 EPS means something very different for a $20 stock than for a $500 stock. That's where the next ratio comes in.
The P/E ratio
The price-to-earnings ratio (P/E ratio) divides a stock's current price by its EPS, showing how much investors are currently willing to pay for each $1 of the company's annual earnings.
A P/E of 20 means it would theoretically take 20 years of the company's current earnings to "earn back" the price you paid for the share (ignoring growth, dividends, or changes in profit). A lower P/E generally suggests investors are paying less per dollar of current profit, while a higher P/E suggests they're paying more — but a high P/E is not automatically a red flag, which brings us to growth companies.
Why growth companies trade at high P/E multiples
The P/E ratio only looks at current earnings, but investors are really paying for a company's future earnings — current profit is just the most convenient number available today. A company growing its profits at 30% a year will earn vastly more in five years than a company growing at 3% a year, even if both currently report identical profits today. Investors are willing to pay a much higher multiple of current earnings for the fast-growing company, because they expect the "E" in the P/E ratio to rise quickly in the years ahead, which effectively brings the multiple back down to a more reasonable level once you look a few years forward instead of at today's snapshot. This is why young, fast-growing technology companies often trade at P/E ratios of 40, 60, or higher, while a mature, slow-growing utility company might trade at a P/E of 12-15: the market is pricing in dramatically different expectations about how fast profits will grow.
Company A has a P/E of 40, Company B has a P/E of 12. Does that mean Company B is the better investment?
Reveal Answer
Not necessarily. A lower P/E doesn't automatically mean a stock is a better or "cheaper" investment — it depends heavily on why the P/E is what it is. Company A's P/E of 40 might be entirely justified if it's growing profits rapidly (say, 35% a year), because its earnings could catch up to and eventually surpass what the price implies. Company B's P/E of 12 might look "cheap," but could reflect real problems: slowing growth, declining industry prospects, or higher risk that investors are pricing in by demanding a lower multiple. Investors sometimes use the PEG ratio (P/E divided by expected earnings growth rate) to account for this — a high P/E paired with high growth can result in a similar or even lower PEG than a low P/E paired with little to no growth. The honest answer is that P/E alone is a starting point for investigation, not a final verdict — you'd need to understand each company's growth prospects, competitive position, and risks before concluding which is the better investment.