Valuation basics: P/E and beyond

Is a stock at $300 expensive and a stock at $15 cheap? Not necessarily — the share price alone tells you almost nothing. Valuation compares the price to what you're getting for it: earnings, sales, or cash flow. Traders who ignore valuation often buy the most popular stocks at the most optimistic moment. Traders who rely on it alone often short great companies far too early. This lesson gives you the working tools, and the judgement to use them.

What you'll learn

• The price-to-earnings (P/E) ratio and what it implies
• Trailing vs forward P/E
• Adjusting for growth with the PEG ratio
• Price-to-sales and EV/EBITDA — for companies P/E doesn't suit
• How to use valuation as a trader, without treating it as a timing signal

1. The P/E ratio

P/E = share price ÷ earnings per share

(Illustrative.) Share price $60, EPS $3.00 → P/E = 20.

A P/E of 20 means investors are paying $20 for every $1 of annual earnings. Another way to see it: the earnings yield is 1 ÷ 20 = 5%.

A P/E is only meaningful compared with something: the company's own history, its competitors, its sector, or the overall market.

2. Trailing vs forward P/E

(Illustrative.) Price $60. Trailing EPS $3.00 → trailing P/E 20. Forecast EPS $4.00 → forward P/E 15. The gap shows the market expects strong earnings growth — and if that growth fails to appear, the "cheap" forward P/E disappears.

3. Adjusting for growth: PEG

A fast-growing company deserves a higher P/E than a slow one. The PEG ratio adjusts for this:

PEG = P/E ÷ expected annual EPS growth rate (%)

Company A looks expensive on P/E but, relative to growth, is priced more cheaply than B. PEG depends entirely on the growth estimate, so treat it as a rough guide.

4. When P/E doesn't work

5. Using valuation as a trader

Valuation tells you what is priced in, not when price will move. Expensive stocks can get more expensive for years; cheap ones can stay cheap.

Practical uses for traders:

• Expectation risk: a stock on a very high P/E has little room for disappointment. Earnings misses can hit it much harder.
• Context for moves: a sector re-rating (P/E expanding or shrinking across a whole sector) often reflects changing interest rates or growth expectations.
• Filtering: combine valuation with trend. For example, look for strong uptrends in companies whose valuation hasn't become extreme relative to their growth.

Worked example

(Illustrative.) Two companies in the same sector both report earnings slightly below consensus.

The high-valuation stock was priced for perfection; the small miss forced a large reset of expectations.

Common beginner mistakes

• Judging "cheap" or "expensive" by share price alone.
• Comparing P/Es across very different industries.
• Trusting forward P/E without questioning the estimates.
• Buying cyclicals on a low P/E at the top of the cycle.
• Using valuation as a timing signal instead of as context.

Key terms

Practice

1. Find the trailing and forward P/E for three companies in the same sector. Which looks cheapest, and why might that be?
2. Calculate the PEG ratio for each using consensus growth estimates.
3. Find one unprofitable growth company and calculate its price-to-sales ratio.
4. Look at a recent earnings reaction for a high-P/E stock and a low-P/E stock. How big were the moves relative to the surprise?

Quick recap

• P/E compares price to earnings; it's only meaningful relative to history, peers, or the market.
• Forward P/E looks ahead but depends on estimates; trailing P/E is factual but backward-looking.
• PEG adjusts for growth; P/S, EV/EBITDA, and P/B suit companies where P/E doesn't.
• Beware cyclicals that look cheap at peak profits.
• Valuation tells you what's priced in, not when price will move.