The price of a dollar of profit
Divide a company’s share price by its earnings per share and you get the price to earnings ratio. If a share costs $50 and earned $2 last year, the ratio is 25. You are paying $25 for each dollar of annual profit.
A rough way to hold it in your head: at an unchanging level of profit, the ratio is the number of years of earnings you are paying up front. That framing makes it obvious why a very high ratio carries expectations with it. Nobody pays fifty years of current profit unless they expect profit to grow substantially.
Costco, and the price of a good reputation
Costco has recently traded near $900 a share while earning roughly $16.50 per share. Divide 900 by 16.5 and the ratio comes out near 55.
By any traditional measure that is expensive, and Costco has been expensive by that measure for many years while continuing to perform. Investors are paying for membership renewal rates that barely move and a business model that keeps working. Whether that price is justified is a genuine argument, and the ratio itself does not settle it.
Rounded illustrative figures. The point is the method and the argument, not a view on the share.
Why a low ratio is often a warning
Beginners naturally assume a low ratio means a bargain. Frequently it means the market expects profit to fall. A company trading at 6 times earnings is often a business whose customers are drifting away, and buying it because the ratio looks cheap is how people meet what investors call a value trap.
Cyclical businesses invert the logic completely. Carmakers and miners look cheapest at the peak of their cycle, when profit is temporarily enormous, and look absurdly expensive at the bottom when profit has collapsed. For those companies a low ratio is a late-cycle warning rather than an invitation.
Comparing it without fooling yourself
Comparing ratios across industries produces noise. Software companies routinely trade at 30 or more because growth is expected; banks and carmakers often sit under 12 because their earnings are cyclical and capital-hungry. Neither group is mispriced simply for being in its usual range.
Two comparisons carry real information. First, the company against its own ratio over the past five or ten years. Second, the company against its closest competitors today. Both keep the comparison inside a world where the same expectations apply.
Writing it into a Stax plan
The ratio works best as one condition among several rather than as the rule itself. A filter asking for a reasonable ratio together with genuine profitability and controlled borrowing describes sensibly priced quality, while a filter asking only for a low ratio mostly finds companies in trouble.
Whatever combination you choose, test it rather than trusting it. Stax replays the plan across five or more years of real prices, showing every buy and sell with the reason attached, so you can see whether the valuation rule helped or simply led you into declining businesses.