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Stock Market

Valuation ratios

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Valuation ratios

Price-to-earnings, price-to-book, price-to-sales, EV/EBITDA, and PEG ratios are the languages investors speak to compare value and identify relative bargains. They compress a company's financial reality into a single number: Is this business trading cheap or expensive relative to its peers, relative to its own history, or relative to intrinsic value? These multiples are useful screening tools to sort the market quickly, but they also seduce careless investors into false precision and false conclusions. A stock trading at 15 times earnings might be dirt-cheap or catastrophically expensive, depending on what drives those earnings, whether they are sustainable, and whether they will grow.

This chapter maps the landscape of valuation multiples and teaches you their strengths and hidden assumptions. Price-to-earnings is intuitive but distorted by temporary earnings spikes, accounting choices, and varying capital structures—a capital-heavy business will always have lower reported earnings than an asset-light business earning the same economic profit. Price-to-sales is more resilient to accounting games but ignores profitability entirely; two companies with the same price-to-sales multiple can have vastly different profit margins and cash generation. Enterprise value to EBITDA strips out capital structure and one-time items, but EBITDA itself can hide deteriorating cash flow—a company can report stable EBITDA while actually burning cash due to working capital changes or required capital expenditures. Each multiple answers a slightly different question and works best for comparing companies in the same industry with similar growth profiles, capital structures, and profitability.

The deeper lesson is this: multiples are useful for screening and for anchoring your thinking, but they should never replace cash-flow thinking. A company trading at five times earnings might be dirt-cheap if it can grow earnings 40 percent annually for the next decade, and extremely expensive if earnings are declining or propped up by accounting adjustments and one-time gains. This chapter teaches you how to use multiples both defensively (to avoid obvious traps and overvalued names that could crater) and offensively (to identify candidates for deeper analysis and possible investment), and crucially, how to recognize when a multiple-based valuation is lying to you or misleading you.

Growth rate and valuation multiples​

The relationship between growth rate and valuation multiples is nonlinear. A company growing 5 percent deserves a lower multiple than one growing 30 percent. But two companies both growing 30 percent deserve different multiples if one is profitable and one is not, or if one is sustainable and one is not. The PEG ratio (price-to-earnings divided by growth rate) attempts to capture this relationship, but it oversimplifies. This chapter teaches you to think about multiples in the context of growth and quality.

Comparing multiples across time and markets​

A stock trading at 15 times earnings might be cheap in a market where the average P/E is 20, or expensive in a market where the average is 10. Historical context matters. Interest rate environment matters. Industry structure matters. Comparing a single company's multiple in isolation means nothing. You must compare it to peers, to history, and to alternatives. This chapter teaches you to make meaningful multiple comparisons that inform your thinking rather than mislead it.

Articles in this chapter​