Chapter 5: Valuation for civilians
Two companies each earned $5.00 per share last year. One trades at $40, the other at $300. Most beginners feel certain the $40 stock is the cheaper one, and the entire discipline of valuation exists because that feeling is unreliable. Chapter 1 showed that price alone says nothing about size. This chapter goes further: price alone says nothing about cheapness either. Cheapness lives in the relationship between what you pay and what the business earns, and one ratio captures it.
What the P/E actually says
Chapter 2 introduced the multiple: what the market pays for each dollar of a company's annual earnings. Its most common form is the price-to-earnings ratio, or P/E, which is simply the share price divided by earnings per share. Cascade Coffee from Chapter 4 earns $2.40 a share; at $48, its P/E is 48 divided by 2.40, which is 20. You are paying $20 for every $1 of yearly profit.
Read it that way every time and the mystique drains out. A P/E of 20 means a $20 price tag on a recurring $1 of earnings. The company a few pages back trading at $40 on $5.00 of earnings carries a P/E of 8: a $8 tag on the same recurring dollar. The $300 stock on $5.00 of earnings carries a P/E of 60. Per dollar of profit, the $40 stock costs 8 and the $300 stock costs 60, so the "expensive" question has a real answer once you divide.
The flip
The single most useful trick in this chapter takes five seconds. Flip the P/E upside down and it becomes the earnings yield: the company's annual earnings as a percentage of what you paid. A P/E of 25 means $1 of earnings for every $25 invested, and 1 divided by 25 is 4%. A P/E of 20 flips to 5%. A P/E of 8 flips to 12.5%. A P/E of 60 flips to about 1.7%.
The flip matters because a percentage yield is comparable to everything else in your financial life. You know instinctively how to react to a savings account paying 4%. A stock at a P/E of 25 is handing its owners a 4% stream of earnings today, and unlike the savings account, that stream can grow, shrink, or vanish. Suddenly the question is concrete: what would this company's earnings need to do to make 4% today a good trade against the alternatives, given the risk that the stream moves.
Three companies, three promises
Put the flip to work on three stocks, two of them new and fictional, one an old friend:
| Company | Price | EPS | P/E | Earnings yield |
|---|---|---|---|---|
| Steady Mills (flour) | $40 | $5.00 | 8 | 12.5% |
| Cascade Coffee | $48 | $2.40 | 20 | 5.0% |
| Lumen Labs (software) | $300 | $5.00 | 60 | 1.7% |
Each price is a sentence about the future, written by everyone trading the stock. Decode them one at a time.
Steady Mills at a P/E of 8 offers a 12.5% earnings yield, which sounds like free money until you ask why thousands of investors are leaving it on the table. They are not asleep. A multiple that low usually means the market expects those $5.00 of earnings to shrink. If the market is wrong and earnings merely hold steady, buyers at $40 do very well. If the market is right, the E in the ratio falls and the bargain dissolves. Cheap prices are forecasts of decline, and sometimes the forecast is correct.
Cascade Coffee at 20 carries roughly an ordinary price for an ordinary good business: a 5% earnings yield plus modest growth expectations, in the neighborhood where large US companies have often traded historically.
Lumen Labs at 60 is the interesting one. Its 1.7% earnings yield is unacceptable as a standing-still return, so the price only makes sense if earnings grow dramatically. Make the expectation concrete. Suppose you want your money to double over the next decade, about 7% a year, and suppose Lumen's multiple drifts down to a normal 20 as it matures. Then the price must reach about $600 on a P/E of 20, which requires EPS of $30. Earnings would have to grow from $5.00 to $30.00, six times over, roughly 20% a year, every year, for ten years. Companies have done this. The point of the arithmetic is that buying at 60 times earnings means needing it to happen just to earn an ordinary return. The growth is not a bonus at that price. It is the entry fee.
That exercise, run in reverse, is the expectations decoder, and you can point it at any stock you own or want. Enter a P/E and see the growth it quietly assumes:
The other yardsticks, briefly
Price-to-sales (P/S) divides the company's total market cap by its revenue, and exists mainly for companies with no E to put under a P. A young company losing money can still be compared on sales. Handle it with care, because sales are not profits: a 3% margin grocer and a 30% margin software firm at the same P/S are wildly different purchases. P/S works best comparing a company to its own history and to close rivals.
PEG divides the P/E by the expected earnings growth rate, trying to make a 60-multiple grower comparable to an 8-multiple plodder.
The G in PEG is a forecast, usually an analyst's guess about the next five years, and such guesses have a long record of missing badly in both directions. The P and the E are facts; the G is a hope with a decimal point. Use PEG as a rough screen if you like, and never as proof that a fast grower is "actually cheap." Precision built on a guess is still a guess.
Book value, the accounting value of a company's assets minus its debts, anchored valuation for a century when value meant factories, rail, and inventory. Most of today's corporate value lives in software, brands, and people, which the balance sheet carries at roughly zero. Price-to-book still earns its keep for banks and insurers, whose assets really are financial, and can quietly retire from your toolkit otherwise.
Multiples move, and that is the danger
Everything so far treated the multiple as a snapshot. Over time it moves, sometimes brutally, and Chapter 2's Harbor Foods showed the gentle version: a slide from 20 to 16 times earnings cost shareholders $40 a share even while the business doubled its profits.
History supplies the rough versions. In 2000, large technology companies traded at multiples that assumed decades of flawless growth; over 2000 through 2002 those multiples collapsed, and some genuinely excellent businesses spent years growing into prices paid at the peak. In 2021, money-losing and high-growth companies commanded record sales multiples; through 2022, many lost more than half their value while their revenues kept rising. In both episodes, the companies often performed fine. The price had simply prepaid for too much future, and the multiple gave it back.
The two honest uses of valuation
Valuation will not tell you what a stock does next year; 2000 and 2021 minted experts who were right about the multiple and wrong about the timing for years. It earns its place in your toolkit for two humbler jobs.
The first is setting expectations. The earnings yield tells you what the business hands you if nothing improves, and the decoder tells you what must happen if you paid for improvement. Owners who know they bought a 20%-growth requirement hold differently, and sell differently, than owners who thought they bought a lottery ticket.
The second is avoiding euphoria. You will rarely identify the exact top, and you do not need to. Knowing that 60 times earnings demands a decade of near-perfection is enough to keep such bets small, which is Chapter 13's territory.
The dishonest use is precision. Anyone quoting a "fair value" of $137.42 has stacked guesses about growth, margins, and rates into a number with false decimal places. Valuation is a rangefinder, never a sniper scope.
Before buying, flip the P/E into an earnings yield and ask what has to go right to beat a boring alternative. Pay a high multiple only knowingly, sized for the chance that the growth arrives and the multiple still shrinks.
A broker once pitched Hugo a department-store chain at "only 8 times earnings, half the market's multiple, a blue chip on sale." Hugo had just learned the flip and liked the look of a 12.5% earnings yield. What he skipped was the question the price was asking: foot traffic had fallen for six straight years, and the market was pricing decline, not a discount. Earnings slid about 13% a year; five years later EPS had halved from $5.00 to roughly $2.50, and at the same multiple of 8 the stock sat near $20, down half from his $40 entry. The P/E never looked expensive on the way down. Hugo keeps the trade confirmation in his desk and calls it his tuition receipt: a low multiple is the market's forecast, and sometimes the market is right.
Key takeaways
- The P/E is the price of $1 of annual earnings. Cascade Coffee at $48 with $2.40 of EPS trades at 20, meaning $20 per recurring dollar of profit.
- Flip any P/E into an earnings yield: 25 flips to 4%, 20 to 5%, 8 to 12.5%, 60 to about 1.7%. Yields are comparable to everything else you own.
- High multiples are prepaid growth. At 60 times earnings, roughly 20% yearly earnings growth for a decade can be needed just to earn an ordinary return.
- Low multiples are forecasts of decline that are sometimes correct; Hugo's 8x retailer halved while looking cheap the whole way down.
- Multiples compress: 2000–2002 and 2021–2022 both punished prepaid futures even when businesses executed. Use valuation to set expectations and dodge euphoria, never for precision.
Sources: Investor.gov: Introduction to investing · Investor.gov: Stocks basics · FINRA: For investors