Corporate Valuation: P/E Ratios, EPS, and What Stock Prices Really Mean
In the second half of Chapter 4 of Stock Market Cash Flow (ISBN: 978-1-937832-48-3), Andy Tanner zooms in from analyzing entire countries to analyzing individual companies. Same fundamental analysis principles, just a different scale.
And he starts with a lemonade stand. Seriously.
The Lemonade Stand That Teaches You Stock Valuation
Andy’s sons started a business called “Tanner Brothers Ice Cold Lemonade.” Here’s how it went:
- Revenue: $50
- Expenses: $20
- Earnings: $30
Simple enough. They made $30 in profit. Now here’s where it gets interesting.
If the lemonade stand issued 100 shares of stock, each share would represent 30 cents of earnings. That’s called Earnings Per Share (EPS).
EPS = Total Earnings / Number of Shares = $30 / 100 = $0.30 per share
This number is important because it tells you how much profit each share of stock actually generates. It’s one of the first things to check when looking at any company.
The P/E Ratio: More Useful Than Stock Price
Here’s where Andy makes his best point in this section. Stock price alone doesn’t tell you if something is a good deal.
He uses three neighborhood businesses to explain:
- Tanner Brothers Lemonade: Stock price $3, EPS $0.30
- Smith Brothers Lawn Mowing: Stock price $5, EPS $1.00
- Jones Brothers Window Washing: Stock price $1, EPS $0.05
If you just looked at price, the window washing business looks cheapest at $1 per share. But that’s misleading.
The Price-to-Earnings ratio (P/E) tells a different story:
- Tanner Brothers: $3 / $0.30 = P/E of 10
- Smith Brothers: $5 / $1.00 = P/E of 5
- Jones Brothers: $1 / $0.05 = P/E of 20
The lawn mowing business actually gives you the most bang for your buck. You’re paying $5 for every $1 of earnings. The window washing business? You’re paying $20 for every $1 of earnings. That “cheap” $1 stock is actually the most expensive when you look at what you’re getting.
Andy’s key lesson: Price is what you pay. Value is what you receive. Don’t shop for stocks like you’re shopping at a store looking for the lowest price tag. A $500 stock can be a better deal than a $5 stock.
The Apple Example
Andy uses a real-world example that drives this home. At one point, Apple stock was trading at $500 per share. Most people looked at that and thought “way too expensive.”
But the P/E ratio was only 13. The NASDAQ average at the time was 17. So from an earnings perspective, Apple was actually cheaper than the average stock on the exchange. People who understood P/E ratios saw the value. The stock continued climbing to $700.
Price alone is misleading. Always look at what you’re getting for your money.
PEG Ratio: Adding Growth to the Picture
The P/E ratio has a weakness. It only looks at current earnings. What about companies that are growing fast?
During the dot-com boom, people were paying P/E ratios of 200 or more for tech stocks. That sounds insane, and a lot of the time it was. But some of those companies were growing at crazy rates. Investors were betting on future earnings, not current ones.
The PEG ratio (Price/Earnings/Growth) adds growth as a third factor. It takes the P/E ratio and divides it by the expected earnings growth rate.
- A PEG of 1 means the stock is fairly priced for its growth
- A PEG below 1 might mean the stock is undervalued relative to its growth
- A PEG above 1 might mean you’re overpaying for the growth
It’s not perfect, but it helps you figure out if a high P/E is justified by actual growth or if people are just caught up in hype.
Market Capitalization: How Big Is This Company?
There’s another number Andy walks through: market cap. The formula is straightforward.
Market Cap = Share Price x Number of Outstanding Shares
If a company has 1 million shares and each trades at $50, the market cap is $50 million. This number tells you the total value of the company as the market sees it.
Companies get sorted into categories based on market cap:
- Large-cap: Big, established companies. Think Apple, Microsoft, Amazon. Less risky, but also less room for explosive growth.
- Mid-cap: Medium-sized companies. A mix of stability and growth potential.
- Small-cap: Smaller companies. More growth potential, but also more risk.
- Micro-cap: Very small. High risk, high potential reward.
Understanding market cap helps you know what kind of company you’re dealing with. A large-cap stock isn’t going to double overnight, but it’s probably not going to disappear either. A micro-cap could do either.
Key Vocabulary to Know
Andy wraps up this section with a vocabulary list. These are terms you’ll run into constantly:
- PE (Price-to-Earnings): How much you pay per dollar of earnings
- PEG (Price/Earnings/Growth): PE adjusted for expected growth
- Market Cap: Total market value of all shares
- Enterprise Value: Market cap plus debt, minus cash. A more complete picture of what the company is worth
- Trailing PE: Based on the last 12 months of actual earnings
- TTM (Trailing Twelve Months): The time period for trailing PE
- Forward PE: Based on estimated future earnings
- Intraday Price: The stock’s price during the current trading day
Try It Yourself
Andy suggests a hands-on activity, and it’s a good one. Go to Yahoo Finance or Google Finance. Pick a few companies you’re interested in. Look at their key statistics. Find the P/E ratio, PEG ratio, and market cap for each one.
Compare them. Which company gives you the most earnings per dollar? Which one is growing fastest? Which one is overpriced compared to its peers?
You don’t need to buy anything. Just practice reading the numbers. That’s how fundamental analysis becomes second nature. You start seeing value instead of just price.
The Takeaway
The biggest shift in this chapter is going from “what does the stock cost?” to “what is the stock worth?” Those are two completely different questions. Price is easy to find. It’s right there on the screen. But value takes a little work to figure out.
P/E ratios, EPS, PEG, and market cap are your starting tools. They’re not complicated. And once you start using them, you’ll never look at a stock price the same way again.
Next up, we move to Pillar 2: technical analysis. That’s where charts come in.