How investors decide what a stock is really worth.
Valuation isn’t about finding “cheap” stocks. It’s about understanding what you’re paying today for future earnings and cash flow. Price alone means nothing without context.
P/E Ratio — Price vs. Earnings
The price-to-earnings ratio shows how much investors are willing to pay for one dollar of profit.
How to think about it:
A higher P/E means the market expects stronger future growth or stability. A lower P/E can signal undervaluation, slower growth, or higher risk.
Real-world example:
A mature consumer company trades at a lower P/E because its growth is slow but predictable. A fast-growing technology company trades at a higher P/E because investors expect earnings to rise significantly in the future.
P/E is most useful when comparing companies in the same industry.
Growth — The Justification for Price
Growth explains why a stock deserves a higher or lower multiple.
What matters most:
Revenue growth consistency, margin expansion, and earnings durability.
Real-world example:
Two companies trade at the same P/E. One grows earnings at 15 percent per year, the other at 3 percent. Over time, the faster-growing business often delivers better returns because its earnings base compounds more quickly.
High growth can justify a higher valuation, but only if it’s sustainable.
Cash Flow — The Reality Check
Cash flow shows whether earnings translate into real money.
Key focus:
Operating cash flow and free cash flow.
Real-world example:
A company reports strong profits but generates little free cash flow due to high capital spending. Another company earns less on paper but produces steady free cash flow. Long-term investors often prefer the second because cash can be reinvested, used to pay down debt, or returned to shareholders.
Cash flow is what ultimately supports dividends, buybacks, and resilience during downturns.
Putting It Together
Strong valuation setups often include:
Reasonable P/E relative to growth
Consistent revenue and earnings expansion
Reliable free cash flow generation
Real-world example:
A company with moderate growth, strong cash flow, and a fair valuation may outperform an expensive high-growth stock if expectations fall short.
Valuation is about trade-offs. You’re always balancing price, growth, and cash flow. The best investments aren’t the cheapest or the fastest-growing—they’re the ones where expectations are wrong in your favor.