Investing in the stock market can be intimidating, especially when trying to determine whether a stock is priced attractively. You've likely heard the phrase "buy low, sell high," but what does that actually mean? When is a stock's price considered "low"? Is it $10 per share? $100? There's no perfect answer, but one tool that can help gauge whether a stock is expensive or cheap is the use of stock multiples.

What Are Stock Multiples?

A stock multiple is a ratio that compares a stock's price to some fundamental aspect of the company's business, such as earnings, book value, or cash flow. By using multiples, investors can better understand how much they are paying for a company's underlying business. One of the most commonly used multiples is the price-to-earnings (P/E) ratio, which compares a stock's price to the company's earnings per share (EPS).

Think of a multiple like the price per pound at a butcher shop. If you're shopping for meat, it's difficult to compare total prices since the quantity you get is different for each cut. But by looking at the price per pound, you can figure out which cut offers the best value. Similarly, multiples allow you to compare the price of a stock relative to the business fundamentals you're purchasing.

Understanding the P/E Ratio

The P/E ratio is one of the most popular and straightforward stock multiples. It's calculated by dividing the stock's current price by its earnings per share. For example, if a company has 1 million shares outstanding, each trading at $30, and its net income last year was $2 million, the P/E ratio would be 15. This means you're paying $15 for every $1 of the company’s earnings.

This type of P/E ratio is known as a trailing P/E because it uses historical earnings data. The trailing P/E gives you an idea of how much investors are willing to pay for each dollar of the company’s profit. However, it has limitations—most notably, it’s backward-looking. Since stock markets are forward-looking, many investors prefer to use a forward P/E ratio, which divides the stock's price by projected future earnings. This forward-looking approach attempts to account for expected growth, such as a new product launch or market expansion.

Comparing Multiples

Multiples are relative measures, meaning they are most useful when compared to other multiples. For example, you can compare a stock's current P/E ratio to its historical P/E ratios to see how the company’s valuation has changed over time. If a company’s earnings are expected to increase but its stock price has fallen, the multiple may contract, indicating that investors value the company’s profitability less than they used to. Conversely, if earnings fall but the stock price rises, the multiple may expand, suggesting investors are paying more for less profit.

Another way to use multiples is by comparing them to industry peers. If you find that a company’s P/E ratio is lower than its historical average but higher than its peers, it might indicate that the stock is still relatively expensive. On the other hand, a lower multiple compared to peers might suggest the stock is undervalued.

The Limits of Multiples

As helpful as multiples can be, they are limited in the insights they provide. For example, a higher P/E ratio might be justified if a company is growing faster than its peers. High-growth companies, particularly in the tech sector, often have higher multiples because investors are willing to pay more for the potential of rapid earnings growth. Conversely, just because a stock has a low P/E ratio doesn’t mean it’s a good buy. The company’s fundamentals might have deteriorated, justifying the lower valuation.

Consider this analogy: Imagine you’re at a butcher shop and see two steaks—one priced at $10 per pound and the other at $3 per pound. The cheaper steak might seem like a bargain, but if it’s expired or of lower quality, it’s not really a good deal. Similarly, a stock with a low P/E ratio might be a “value trap,” where the low price reflects justified concerns about the company’s future profitability.

The Role of Fundamentals

While multiples like the P/E ratio can help you gauge a stock’s price level, they should not be the sole basis for investment decisions. A thorough understanding of a company’s fundamentals—such as its business model, competitive advantages, management quality, and future growth prospects—is essential. Warren Buffett famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." This means it’s often worth paying a bit more for a high-quality company than buying a cheap stock with poor prospects.

Conclusion

Stock multiples are valuable tools for understanding how a stock is priced relative to its earnings, book value, or other fundamentals. However, they are just one piece of the puzzle. To make informed investment decisions, you need to combine multiples with a solid understanding of the company’s business and future potential. By doing so, you can avoid value traps and make smarter investment choices.

The next time you encounter a stock with a low multiple, take the time to dig deeper into the company’s fundamentals. Ensure that the low price reflects a temporary setback rather than a permanent decline in the company’s prospects. In the end, a well-researched investment, backed by a solid understanding of multiples and fundamentals, is far more likely to pay off in the long run.

This is market commentary, not personalized financial, real estate, tax, legal, or otherwise advice. It is not and shall never be deemed reasonably sufficient information for the purposes of evaluating a security. I may hold beneficial positions for or against the securities discussed. This content is solely to provide generalized perspective, facts, and commentary.