PosiStep 15: Valuation: is a stock cheap or expensive?
Everyone wants to know whether a share is cheap or expensive. There is no single number that answers it. This PosiStep shows how to think about valuation, and the traps that catch beginners.
Price is not value
The price is what the market charges today. The value is what the business is really worth, based on the profits and cash it can produce in the future. Prices swing every day; a business's value changes much more slowly.
Valuation is the attempt to judge whether today's price is reasonable for that future. It always involves estimates, so two careful people can reach different answers.
Cheap or expensive compared with what?
A share is cheap or expensive only compared with something: its profits (P/E), its assets (P/B), its cash flow, its growth, its own history, and similar companies (peers).
A P/E of 25 may be expensive for a slow, steady utility and cheap for a company growing profits 30% a year. A share price of ₹10 tells you nothing at all about cheapness (PosiStep 4).
Growth can justify a high price
Investors often pay a high P/E for companies expected to grow fast, because future profits could be much larger than today's. The risk is that if growth disappoints, the P/E can fall sharply along with the price.
Paying a high price leaves little room for error; paying a sensible price for a good business leaves more.
The value trap
A very low P/E or a P/B below 1 can look like a bargain, but sometimes it is low for good reasons: shrinking sales, heavy debt, poor governance or red flags. A share that looks cheap and keeps getting cheaper is called a value trap.
Always ask why a share is cheap before calling it a bargain.
The 52-week range and margin of safety
A share near its 52-week low is not automatically cheap, and one near its 52-week high is not automatically expensive. The range shows where the price has been, not what the business is worth.
Careful investors look for a margin of safety: buying only when the price is comfortably below their own estimate of value, so that mistakes in the estimate are less costly.
Where PositoAI fits
The Funda tab compares each company's P/E and P/B with similar companies. The 52-week Top 10 lists show companies near their highs and lows, including high score near 52-week low, and Compare puts companies side by side.
Key terms
- Valuation
- Judging whether a price is reasonable for a company's future profits and cash.
- Peers
- Similar companies in the same industry, used for comparison.
- Value trap
- A share that looks cheap but is cheap for good reasons and keeps falling.
- 52-week high / low
- The highest and lowest price of the past year; not a measure of value.
- Margin of safety
- Buying well below your estimate of value, to allow for mistakes.
- Growth premium
- The higher price investors pay for expected fast growth.
Try it
Made-up company Hawk Tech has a P/E of 40 and profits growing 30% a year. Made-up company Dove Mills has a P/E of 8 and profits falling 15% a year. Which statement is most fair?
A high P/E can be explained by growth, and a low P/E by shrinking profits. You need to judge the future of each business, not the P/E alone.
See it live on PositoAI
Open the high score near 52-week low list for India and pick one company. Open its Funda tab and check whether its P/E is low or high compared with similar companies.
What this does not tell you
Valuation is an estimate, not a fact. Even careful estimates can be wrong, and a fair price today can become unfair if the business changes. PositoAI shows the figures; the judgement is yours.
Quick quiz
What is the difference between price and value?
Price is what you pay; value depends on the profits and cash the business can produce in future.
A share is near its 52-week low. This means:
The 52-week range only shows where the price has been; it says nothing on its own about value.
What is a value trap?
A value trap looks like a bargain on ratios, but problems in the business keep the price falling.
Why might investors accept a high P/E?
Expected fast growth can justify paying more for today's profits, though it adds risk if growth disappoints.
What is a margin of safety?
Buying comfortably below estimated value leaves room for mistakes in that estimate.
Answer every question on this page correctly to complete this PosiStep.
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PosiCourse is for education only. It does not recommend buying or selling any share. Examples with made-up numbers are not real companies. PositoAI is for research and education only and is not investment advice.