A stock can rise and still be a bad buy if you overpaid. So how do you tell whether a price is cheap or expensive? This is valuation — and it’s more art than science.
Price vs value
The price is what the market charges. Value is what the company is actually worth to an owner, based on the profits it will earn. They’re often close, but not always — and the gap is where opportunity (and risk) lives. Valuation is the attempt to estimate value so you can judge the price.
Earnings per share (EPS)
Start with profit. Earnings per share slices the company’s profit across its shares:
EPS = annual profit ÷ shares outstanding
A company earning $100 million with 50 million shares has an EPS of $2 — two dollars of profit behind each share.
The P/E ratio
The most common valuation gauge compares price to those earnings:
Price-to-earnings (P/E) = share price ÷ EPS
A $40 stock with $2 EPS has a P/E of 20 — you pay $20 for every $1 of annual earnings. Roughly, it’s how many years of current earnings you’re paying for.
- A high P/E means investors expect strong future growth (they’ll pay up now for bigger profits later).
- A low P/E can mean a bargain — or a company the market expects to shrink.
A P/E only means something in context: versus the company’s own history, its industry, and its growth rate. A high P/E isn’t automatically “expensive”, nor a low one “cheap”.
Why valuation is hard
Every valuation rests on guesses about the future — growth, competition, the economy — and reasonable people guess differently. There’s no single correct number, which is exactly why one investor sells while another buys at the same price.
The takeaway
Valuation asks whether a price is fair given the company’s earnings. EPS measures profit per share; the P/E ratio measures how much you pay for it. They’re useful gauges, not verdicts — and because they hinge on an unknowable future, valuation is judgement, not arithmetic. (This is education, not investment advice.)