What "Valuation" Actually Means
A stock isn't expensive at $500 or cheap at $5. Price by itself is meaningless. Valuation asks: how much are you paying for what you get?
A $500 stock that earns $50 of profit per share is cheaper than a $5 stock that earns 10 cents.
The P/E Ratio — Your First Tool
P/E = Stock Price / Earnings Per Share
If a stock is $100 and earns $5 per share, the P/E is 20. You're paying $20 for every $1 of current earnings.
Rough US-market guides:
| P/E | Meaning |
|---|---|
| <10 | Cheap, distressed, or shrinking |
| 10-20 | Typical for mature companies |
| 20-40 | Premium for growth or quality |
| >40 | Very expensive — needs strong future growth to justify |
Always compare within an industry. A 25 P/E is normal for software but expensive for utilities.
When P/E Doesn't Work
- Negative earnings: P/E is meaningless — use P/S
- One-time items: Earnings can be artificially boosted or hurt by tax changes, asset sales, write-offs
- Cyclical companies: P/E looks low at the peak of the cycle and high at the trough — exactly backwards
For unprofitable growth companies, P/S (Price-to-Sales) is more useful. Compare it to the company's history and to peers.
PEG — P/E Adjusted for Growth
PEG = P/E / Annual Earnings Growth Rate (%)
A high P/E can be totally fair if growth is strong. Peter Lynch popularized:
- PEG < 1.0: potentially undervalued
- PEG ~ 1.0: fairly valued
- PEG > 2.0: richly valued
A 40 P/E with 30% growth (PEG 1.3) can be a better deal than a 15 P/E with 0% growth (PEG ∞).
EV/EBITDA — The Pro Version
Enterprise Value (market cap + debt - cash) divided by EBITDA (earnings before interest, tax, depreciation, amortization).
Why pros prefer it: - Capital structure neutral — compares companies with different debt levels fairly - Acquirer's-eye-view — when you buy a company, you take on its debt and get its cash
Typical ranges: 8-12 (mature), 15-25 (growth), 30+ (premium / speculative).
The Value Trap
A "cheap" stock is sometimes cheap for a reason — declining business, bad management, dying industry. A 5 P/E with shrinking revenue is usually a trap, not a bargain. Always pair valuation with quality.
Cheap and good is rare. Expensive and great is common. Cheap and bad is everywhere — that's the trap.