Valuation: cheap or expensive?

Two market stalls sit side by side. Both sell their whole stand for £100. The first earns £10 a year. The second earns £2 a year. Same price tag — but they are not the same deal. For your £100, the first hands you £10 of profit every year; the second, £2. The price is identical. What you get for it is not.

That is the whole trap. A share’s price in pounds tells you almost nothing on its own. What matters is the price next to what the business earns. Cheap or expensive isn’t a number on a screen — it’s a relationship.

Price means nothing without earnings

A share that costs £5 sounds cheaper than one that costs £500. Most people stop there, and they’re wrong to. The £5 share might belong to a company that earns half a penny per share. The £500 share might earn £40 per share. Per pound you put in, the “expensive” one gives you far more profit.

So the question is never “how many pounds is this share?” It’s “how many pounds am I paying for each pound of yearly profit the business makes?”

That ratio has a name: price-to-earnings, or P/E. It is just the share price divided by the earnings per share.

P/E = price ÷ earnings-per-share.

If a share costs £40 and the business earns £2 per share that year, the P/E is 40 ÷ 2 = 20. You’re paying £20 for every £1 of annual profit.

What “20 times earnings” actually means

Here’s a loose but useful way to feel it. A P/E of 20 means you’re paying twenty years of today’s profit to buy your slice. If the company earned exactly the same amount every year and paid all of it to you, it would take twenty years for the profits to add back up to what you paid.

A P/E of 10? Ten years. A P/E of 30? Thirty years.

It’s loose because no business earns the exact same amount forever — that’s the whole point of what comes next. But as a gut check it’s gold. When someone says a stock trades at “forty times earnings,” hear it as: you are paying forty years of current profit, up front, for this slice. That should make you ask a hard question — why would anyone do that?

High and low P/E are bets on the future

The answer ties straight back to something this course already taught: a price already bakes in what the crowd expects (item 5). The P/E is the cleanest place to see that expectation written down.

A high P/E means the crowd expects profits to grow — fast. Pay forty years of today’s profit and it only makes sense if you believe tomorrow’s profit will be much bigger, shrinking that payback time. The high price is a bet on growth.

A low P/E means the crowd expects little growth, or sees real risk — a fading business, a shaky industry, a chance the profit falls. The low price is the market saying “we don’t expect much here, or we’re nervous.”

So the P/E isn’t a verdict. It’s a question made of numbers: what future is this price betting on?

A worked example: Steady vs Rocket

Two companies. Both shares cost exactly £60.

• Steady Foods earns £6 per share this year. P/E = 60 ÷ 6 = 10.
• Rocket Apps earns £2 per share this year. P/E = 60 ÷ 2 = 30.

Same price. But for your £60, Steady hands you £6 of current profit; Rocket hands you £2. On today’s earnings, Steady is the “cheaper” buy — you pay 10 years of profit, not 30.

Does that make Rocket a bad deal? Not necessarily. At a P/E of 30, the market is betting Rocket’s £2 of earnings will climb — to £4, £6, more — over the next few years. If that happens, the £60 price that looked steep becomes a bargain in hindsight, because you locked in a slice of a much bigger future profit.

But the bet can fail. If Rocket’s earnings stay at £2, you overpaid badly — 30 years of profit for a business going nowhere. Meanwhile Steady’s low P/E might hide a different bet: maybe its profit is about to fall, and 10 looks cheap only until the £6 becomes £3.

Same £60 price. Two completely different wagers on what tomorrow holds. The P/E is how you read the wager.

The whole, not the sticker price

Step back. Valuation isn’t a calculation that spits out “cheap” or “expensive” — it’s a way of seeing what a price assumes about a future nobody can actually see. A high P/E and a low P/E are both just the market’s collective guess, priced in pounds, about earnings that haven’t happened yet.

That’s worth holding humbly. “Expensive” can stay expensive for years if the growth genuinely shows up — many great businesses never look cheap and reward their owners anyway. And “cheap” is often a trap: a low P/E that’s low because the business is quietly dying. The ratio doesn’t tell you which. It tells you what’s being bet, so you can ask whether you believe the bet.

You’re not pricing a sticker. You’re reading a room full of strangers wagering on a future, and deciding whether to wager with them. See that, and you’ll never again call a share cheap just because the number is small.