hamsterdam

Imagine your neighbor wants to sell you her small bakery. She makes $10,000 a year in profit after all expenses. How much would you pay for it?

This is the most fundamental question in investing, and surprisingly, many people completely ignore it when buying stocks. They chase companies with cool products, exciting growth stories, or buzzy news coverage. However, the only reason to buy an individual stock is if you believe the current price is too low.

Not because the company is growing fast. Not because you love their products. Only because other investors have underestimated what the company is actually worth.

The Bakery Test

Let’s go back to your neighbor’s bakery. It makes $10,000 per year. If she wants $50,000 for it, that’s a P/E ratio of 5—meaning you’d pay $5 for every $1 of annual profit. At that price, if profits stay steady, you’d earn back your investment in five years.

If she wants $200,000? That’s a P/E of 20. Now you’re paying $20 for every $1 of profit. It’ll take twenty years of steady profits just to break even. You’d need to believe the bakery’s profits will grow substantially to justify that price.

And if she wants $1,000,000 for a bakery making $10,000 a year? That’s a P/E of 100. You’re paying a hundred dollars for every dollar of current profit. You’d need to be absolutely certain this bakery is about to explode in popularity—that the $10,000 today will become $50,000 or $100,000 in a few years—otherwise, you’re massively overpaying.

AMD: A Real-World Example

Now let’s look at AMD, the chipmaker. As of late January 2026, AMD trades at roughly $250 per share with a P/E ratio around 130.

What does that mean in plain terms? For every share you buy, you’re paying about $130 for each $1 of AMD’s current annual earnings per share.

Think about that in bakery terms. If AMD were a local business earning $10,000 a year, you’d be paying $1.3 million for it.

For comparison, the S&P 500—a basket of 500 large U.S. companies—trades at a P/E of about 28. The average stock costs you $28 for every $1 of earnings. AMD costs you nearly four times that.

So Is AMD a Bad Investment?

Not necessarily. Here’s where the math gets interesting.

When you buy AMD at a P/E of 110, you’re making a bet. You’re betting that AMD’s profits will grow dramatically—so dramatically that today’s price will look cheap in hindsight. You’re betting that the consensus view of AMD’s future (which is already optimistic, hence the high P/E) still underestimates how well the company will actually do.

The market already expects AMD to benefit from the AI boom, from data center growth, from capturing market share from Intel. That expectation is baked into the price. For AMD stock to go up from here, the company has to exceed those already-high expectations. It has to surprise to the upside.

If AMD simply meets the already very high expectations? The stock probably goes nowhere. If it disappoints? It could fall hard.

Meanwhile, at a P/E of 110, even if AMD’s business performs brilliantly, you’re starting from an expensive base. Remember: you paid $110 for each dollar of current profit. That’s a lot of future growth already priced in.

Financial theory tells us that the correct price of a stock equals the present value of all the future cash it will generate for shareholders. The P/E ratio is a rough shortcut to understanding whether that future cash flow justifies today’s price.

The P/E ratio is your reality check. It forces you to ask: “What would this look like as a simple business? Would I buy a bakery at this price?”

The Question to Ask

Before you buy any stock, ask yourself one question: How much am I paying for each dollar of this company’s profits?

At a P/E of 15, you might be getting a bargain—or buying a company with dim prospects. At a P/E of 110, you might be buying a future titan—or paying a fortune for hype.

Neither high nor low P/E is automatically good or bad. But understanding what you’re paying, and what growth would need to happen to justify that price, is the difference between investing and hoping.

Your neighbor’s bakery makes this obvious. Wall Street makes it complicated. But the question is the same: Is the price right?