How To Value Stocks: You Already Know How

Learning how to value stocks starts with a question you already understand: What am I getting for the price I’m paying?

You ask that question when buying a house, a car, or a business. The same thinking applies to stocks. Each share represents ownership in a company, and evaluating its price begins with understanding the earnings and cash flow that business can generate.

In this video, FAST Graphs co-founder Chuck Carnevale explains this common sense approach using examples from his book, All Investing Is Value Investing, co-authored with Professor Nathan Mauck.

Think Like a Business Owner

Imagine you own a business that reliably earns $100,000 every year. Would you sell the entire business for $100,000?

Probably not. That offer represents just one year of earnings.

Now consider an offer of $1.5 million. That price equals 15 times the business’s annual earnings—a price-to-earnings ratio, or P/E, of 15.

This simple example connects the price of a business to its earning power. When evaluating a stock, you can apply the same logic: how much are you paying for each dollar of earnings?

What a P/E Ratio of 15 Tells You

A P/E ratio of 15 means an investor pays $15 for every $1 of annual earnings.

Turning that relationship around gives you an earnings yield:

$1 ÷ $15 = approximately 6.67%.

In the hypothetical business example, $100,000 in earnings divided by a $1.5 million purchase price produces the same earnings yield.

That does not mean a stock will pay you a 6.67% dividend or deliver a guaranteed 6.67% return. Companies may retain earnings to reinvest in the business, and future earnings and share prices can change.

Chuck uses a P/E of 15 as a valuation reference—not a universal rule that determines what every company is worth.

Use Historical Relationships to Put Price in Context

In the video, Chuck examines Raymond James Financial (RJF), Johnson & Johnson (JNJ), American Express (AXP), and Amgen (AMGN) to illustrate how stock prices have related to earnings-based valuation references over the periods shown.

FAST Graphs makes those relationships visible. Comparing price with earnings helps investors investigate whether a stock’s valuation appears consistent with its business performance or has moved away from its historical pattern.

Coca-Cola (KO) provides a different example: investors have often assigned it a premium valuation.

These comparisons are starting points for research. A historical relationship does not guarantee that a stock will return to a particular valuation.

Why Growth Changes the Valuation Discussion

A business that grows its earnings rapidly can generate a larger future earnings stream than a slower-growing business. That can support a higher valuation, provided the growth expectations are reasonable.

Chuck uses Alphabet (GOOGL) to illustrate a growth-based valuation reference associated with Peter Lynch: comparing the P/E ratio with the company’s earnings growth rate.

This approach still requires judgment. Investors need to consider whether growth can continue, the risks to the business, and how much future success the stock price already assumes.

Strong growth does not make every purchase price reasonable.

Understand the Power of Compounding

The Rule of 72 offers a quick estimate of how long it takes an amount to double at a constant annual growth rate:

72 ÷ annual growth rate = approximate years to double.

At 10%, the doubling time is approximately 7.2 years. At 20%, it is approximately 3.6 years.

This helps explain why differences in sustained growth can produce large differences over time. But earnings growth and investment returns are different measures. Your return also depends on the price you pay, dividends, and the valuation when you sell.

A Great Business Still Needs a Sensible Price

The central lesson is straightforward: evaluate the business and the price together.

Paying a high valuation can limit future returns even when a company performs well. A more reasonable purchase price can give investors a better starting point, although it cannot eliminate investment risk.

Whether your focus is growth, income, or a combination of both, Chuck’s approach asks you to connect the price you pay with the earning power you receive.