The most common beginner's mistake goes: this stock costs only a few dollars, so it is cheap. Valuation is the craft that shatters this illusion. It does not ask what one share costs, but what the whole company costs - and what you get for that money. Valuation is one of the six areas of the Stock Analyst certification, and the most important one.
Market cap: the company's real price tag
Market capitalization (market cap) is the share price times the number of shares outstanding. A company with a $40 share and 200 million shares has a market cap of $8 billion. Another company with a $400 share but only 10 million shares costs $4 billion - half as much. The price of a single share says nothing at all about the size of the company or about whether it is expensive. That is also why stocks are sorted into large cap and small cap by capitalization, not by their exchange price.
The stock split is related: when a company splits each share into two, the price halves and the share count doubles. The value of your stake does not change by a cent - the same pie is just cut into more pieces.
P/E: how much you pay for profit
The P/E ratio (price to earnings) divides the share price by earnings per share (EPS). A $90 stock earning $6 per share has a P/E of 15 - you are paying fifteen times the annual profit. The higher the P/E, the more expensive the unit of profit you are buying.
P/E is only meaningful to compare within a sector. Software companies routinely trade at higher multiples than utilities, because they grow faster and do not need expensive power plants. Comparing a bank's P/E with a tech company's P/E is like comparing the price per square meter in a capital city and in a village - the number alone decides nothing.
Also mind which profit you are using. Trailing P/E works with reported earnings over the last twelve months, forward P/E with an estimate of future earnings. For a growing company the forward P/E tends to be lower - the market believes profit will rise.
Beyond the sector, it also makes sense to compare a P/E with the stock's own long-term average. When a company traded around a P/E of 15 for years and stands at 25 today, ask what has improved in the business to deserve a markedly higher multiple - and conversely, a P/E far below its own average is an invitation to examine whether the market has cheapened the stock without reason. A stock's own history is the basic quick check of over- or undervaluation.
When profit is missing: P/S, P/B and dividend yield
A loss-making company has no P/E - you cannot meaningfully divide by zero or a negative number. For young growth companies analysts therefore reach for P/S (price to sales), the ratio of price to revenue. Even a company that is still losing money has revenue.
P/B (price to book) compares the market price with the book value of equity per share - useful for banks and asset-heavy companies. And dividend yield, the annual dividend divided by the share price, tells you what percentage of your investment comes back in cash each year: a $6 dividend at a price of $150 means a 4% yield.
Price vs. value: the market prices the future
Price is the amount a stock trades for at a given moment. Value is an estimate of what the business will actually deliver economically. The two routinely diverge - and it is precisely in that gap that investors look for opportunity. Estimating fair value is also the job of the Bulios Fair Price Index.
The key insight is that the market does not price the past but expectations. A company with a P/E of 24 is not automatically overvalued - if its profit grows 20% a year, today's multiple deflates by itself within a few years. Exactly this reasoning is captured by PEG: the ratio of P/E to expected profit growth. It helps distinguish when a higher multiple is paid for by growth and when only by optimism. An overvalued stock is one whose price has outrun a realistic outlook - an undervalued one is priced below its true prospects.
EV and buybacks
Enterprise value (EV) goes one step beyond market cap: it adds debt and subtracts cash. It expresses what it would cost to buy the whole company including its obligations. Two companies with the same market cap but different debt levels suddenly differ through EV - exactly as they should.
And one more mechanism that moves valuation: the buyback. When a company repurchases and retires part of its own shares, the same profit is split across fewer shares - EPS rises without the company earning more. That is why the number of shares outstanding is a figure worth watching.
Test yourself
Valuation is one of the six areas of the Stock Analyst certification exam. If you are a Bulios Black member, you can put the knowledge from this article to the test - the Bulios certification checks everything from market cap to PEG, and passing it puts a certificate right on your profile.