🔎 Reading the Numbers · Lesson 5 of 8 · 8 min
The P/E Ratio & Valuation
🏷️ A $500 stock can be 'cheap' and a $20 stock 'expensive' — price tags alone tell you nothing, same as a $9 burger isn't a deal if it's two sad pickles. The P/E ratio is how investors compare what they're actually paying for a dollar of profit.
💡 Key idea
P/E = price ÷ earnings per share = what you pay for $1 of profit. Only meaningful versus peers, history, and growth.
🧠 Why it matters
A share price by itself is meaningless — you need to know what you GET for it. The PRICE-TO-EARNINGS (P/E) RATIO divides the share price by earnings per share, telling you how many dollars you're paying for each dollar of annual profit. A P/E of 20 means you're paying $20 for $1 of yearly earnings. Lower can mean 'cheaper,' higher means investors expect fast growth (or it's overhyped). But P/E only makes sense in CONTEXT: compare it to the company's own history, its competitors, and its growth rate — a high P/E can be justified by rapid growth, while a low P/E can be a 'value trap' on a dying business. It's a starting question, not a verdict.
🌍 In the real world
🧮 Stock A trades at $100 with $5 EPS (P/E 20). Stock B trades at $40 with $1 EPS (P/E 40). Despite the lower price tag, Stock B is 'more expensive' — you're paying $40 per dollar of profit vs $20. The sticker price fooled you; the P/E didn't.
📌 Takeaways
- P/E = price ÷ EPS = cost per $1 of annual profit
- Share price alone says nothing about cheap vs expensive
- Judge P/E vs peers, history, and growth — not in isolation
📖 Terms in this lesson
P/E ratio: Share price divided by yearly profit per share; how many years of profit you're paying for.
✅ Test yourself
What does a P/E ratio of 20 mean?
- The stock costs $20
- You're paying $20 for each $1 of annual earnings
- The company grew 20%
- There are 20 shares
Answer: B · You're paying $20 for each $1 of annual earnings
P/E is price per dollar of profit — here, $20 paid for $1 of yearly earnings.
Why is a share price alone useless for 'cheap vs expensive'?
- Prices are random
- You must compare it to the profit you get (earnings)
- Higher is always better
- Lower is always better
Answer: B · You must compare it to the profit you get (earnings)
A high or low price means nothing until you know the earnings behind it — that's what P/E captures.
A low P/E might be a 'value trap' when...
- The company is growing fast
- The business is actually declining and cheap for a reason
- The stock is popular
- Earnings are rising
Answer: B · The business is actually declining and cheap for a reason
Cheap isn't always good — a low P/E on a dying business can keep falling. Context matters.
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