What it is

Valuation is the practice of estimating what a company is worth and judging whether its current share price is cheap, fair, or expensive. You do not need a finance degree to start - two simple tools, market capitalisation and the P/E ratio, get you a long way. This lecture explains both and, crucially, why the same P/E can mean very different things in different industries.

How it works

Market capitalisation

Market capitalisation (market cap) measures the total value the market places on a company's equity. The formula is simple:

Market cap = share price x number of shares outstanding

A stock trading at 50 with 200 million shares outstanding has a market cap of 10 billion. Market cap - not the share price alone - tells you the company's size. A 5 stock and a 500 stock can belong to companies of identical value; what differs is how many shares the value is split into. Investors group companies by market cap into large-cap, mid-cap, and small-cap buckets, which roughly correspond to maturity, stability, and risk.

The P/E ratio

The P/E ratio (price-to-earnings) is the single most quoted valuation multiple. It answers: how much am I paying for each unit of the company's annual profit?

P/E = share price / earnings per share (EPS)

If a stock trades at 40 and its EPS is 2, the P/E is 20. One intuitive reading: at a constant level of earnings, you are paying 20 years' worth of current profit for the shares. A higher P/E means the market is paying more per unit of current earnings - usually because it expects those earnings to grow. A lower P/E means the market is paying less, which can signal either a bargain or a business in trouble.

There are two common variants: the trailing P/E uses the last twelve months of actual earnings, while the forward P/E uses analysts' forecast earnings for the year ahead. They can differ substantially for a fast-changing company.

How to use it

Never read a P/E in isolation. Use this checklist:

1. Compare to peers, not the whole market. A P/E of 30 is high for a utility but ordinary for a fast-growing software firm.
2. Compare to the company's own history. Is today's multiple above or below its typical range?
3. Check whether earnings are real and stable. A P/E built on a one-off profit spike is misleading; a tiny EPS can inflate the ratio to a meaningless number.
4. Watch for negative earnings. If a company loses money, EPS is negative and the P/E is meaningless - you must use other measures.

A worked example

Suppose two companies both trade at a P/E of 25.

• Company A is a mature consumer-staples business growing earnings 3% a year.
• Company B is a software company growing earnings 30% a year.

The identical 25 multiple is expensive for A - you are paying a growth-style price for a slow-growing business - but potentially cheap for B, because rapid growth can justify a high multiple. The number alone tells you nothing; context tells you everything.

Why multiples differ by sector

Different industries carry structurally different P/E ranges, and this is normal rather than a mispricing. The main drivers are:

• Growth expectations. Sectors expected to grow fast (technology, biotech) command higher multiples; slow, mature sectors (utilities, banks) trade at lower ones.
• Stability and predictability. Reliable, defensive earnings (consumer staples) earn a premium over cyclical earnings (mining, autos) that swing with the economy.
• Capital intensity and risk. Businesses that need heavy ongoing investment, or carry more debt, often trade at lower multiples.

The practical consequence: comparing the P/E of a bank with that of a software firm is meaningless. Always compare within a sector.

Key takeaway: Market cap measures size (price x shares), the P/E measures how much you pay per unit of earnings, and a 'fair' P/E is sector-relative - judge a multiple only against peers and the company's own history, never in a vacuum.

Strengths & limits

Market cap and the P/E are quick, universal, and easy to compute, which makes them excellent first filters. But they are blunt. The P/E ignores debt, says nothing about cash generation, and breaks entirely when earnings are negative or distorted by one-off items. It is backward- or forecast-dependent, never certain. Treat these multiples as the opening question of valuation - why is this multiple where it is? - not as the final answer.