Valuation Multiples
Relative valuation prices a company by comparing it with peers through a multiple, a ratio of value to a fundamental driver. Equity multiples divide price or market capitalisation by an equity figure, the leading example being the price-to-earnings (P/E) ratio. Enterprise-value multiples such as EV/Sales and EV/EBITDA compare total firm value with revenue or operating cash earnings, and are less distorted by capital structure. A stock looks cheap when its multiple sits below comparable peers and expensive when it sits above, always adjusting for differences in growth, risk and profitability.
Why it matters
Multiples answer the question "what are investors paying per unit of earnings or sales?". A P/E of 15 says you pay fifteen dollars for each dollar of annual profit. The appeal is speed and a market-based reality check. The danger is the word "comparable". A low P/E can mean a bargain or a business the market expects to shrink. EV-based multiples bring debt into the picture, so they compare firms with different leverage on fairer terms.
Formulas
Worked examples
A company earns A$4 per share and trades at A$60. Peers trade at an average P/E of 12. Is the stock cheap or expensive on this multiple?
The stock’s P/E is A$60 divided by A$4, which is 15. That sits above the peer average of 12, so on this single multiple the stock looks relatively expensive, by about 25 percent. Before concluding, an analyst would ask whether the higher multiple is justified by faster expected growth, lower risk or higher profitability. If those do not explain the premium, the stock is dear relative to its peers.
Common mistakes
- ✗A low P/E always means a stock is cheap. A low P/E can be a "value trap" where the market correctly anticipates falling earnings. Cheap requires the low multiple to be unjustified.
- ✗P/E and EV/EBITDA are interchangeable. P/E is an equity multiple sensitive to leverage and tax. EV/EBITDA looks at the whole firm before financing, so they can tell different stories.
- ✗Relative valuation gives the true intrinsic value. Multiples are relative. If the whole peer group is overpriced, a "cheap-versus-peers" stock can still be overvalued in absolute terms.
- ✗A higher multiple just means a more expensive stock. A higher multiple often reflects higher expected growth or lower risk, so the comparison must adjust for those drivers.
Revision bullets
- •Relative valuation prices a firm against peers via multiples
- •Equity multiples include P/E and price-to-book
- •EV multiples include EV/Sales and EV/EBITDA, less distorted by leverage
- •Cheap means a low multiple relative to comparable peers
- •A low P/E can be a value trap, not a bargain
- •Adjust comparisons for growth, risk and profitability
Quick check
A key advantage of EV/EBITDA over the P/E ratio is that it
A stock trading on a low P/E relative to peers is best interpreted as
Connected topics
Sources
- Brailsford, Heaney & Bilson (2015), Ch. 13Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.Covers relative valuation and the price-multiple approach to equity pricing.
- Bodie, Kane & Marcus (2021), Ch. 18Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.Reference treatment of price multiples and comparables in equity valuation.