Price Multiples (P/E, P/B, P/S, EV/EBITDA) and Relative Valuation

Introduction

Ever chat with a friend about investing and wonder how folks decide if a stock is cheap or expensive? One tried-and-true approach is to use price multiples. And while this method sounds fancy, it’s basically about dividing a company’s market value by one of its fundamental measures—like earnings, book value, sales, or cash flow. In this section, we’ll explore why price multiples remain a staple in equity valuation, how to use them correctly, and the pitfalls you should avoid. After all, it can be all too easy to take one glance at a price-to-earnings (P/E) ratio and jump to conclusions. Let’s dig deeper and add a bit of nuance to your toolkit.

Understanding the Basics of Price Multiples

Price multiples provide a simple way to compare different companies or the same company over time. They’re called “multiples” because they tell us how many times a fundamental measure (e.g., earnings) investors are willing to pay.

It’s sort of like buying a house: if two houses are similar in size and location, you might check the price per square foot to see which one’s a better deal. Similarly, in the equity world, we might check the “price per $1 of earnings” or “price per $1 of book value.”

In official terms, price multiples are often used for relative valuation—comparing a company’s metric to averages of peers or entire market indexes. If a company’s P/E is far above or below peers, we naturally ask why.

Below is a simple flowchart illustrating this concept:

    flowchart LR
	    A["Market Price per Share"] --> B["Divide by Earnings per Share <br/> => P/E Ratio"]
	    A --> C["Divide by Book Value per Share <br/> => P/B Ratio"]
	    A --> D["Divide by Sales per Share <br/> => P/S Ratio"]
	    E["Enterprise Value (EV)"] --> F["Divide by EBITDA <br/> => EV/EBITDA Ratio"]

Key Price Multiples

Price-to-Earnings (P/E) Ratio

• Formula:

The P/E ratio is arguably the most well-known price multiple. It answers the question, “How many dollars am I paying for each dollar of this company’s earnings?” Let’s say a stock is trading at $20 per share and its earnings per share (EPS) is $2. Then the P/E is 10. That means the market values each dollar of earnings at $10.

• Common Uses and Considerations

1. Quick Benchmark: You can rapidly compare a company to sector averages or the market.
2. Affected by Accounting Choices: Different methods of depreciation or revenue recognition can distort EPS.
3. Impacted by One-Time Items: A big gain (or loss) in one quarter can inflate (or deflate) EPS, thus skewing the ratio.

From personal experience, I once compared two technology stocks by P/E alone and missed that one had temporarily boosted earnings by selling off a patent. The ratio looked great, but realistically, the underlying operations were still lagging.

Price-to-Book (P/B) Ratio

• Formula:

If you’ve ever heard someone say, “This stock is trading below book value—what a bargain!” that person is referring to the P/B ratio. Book value per share usually represents a firm’s total assets minus liabilities, divided by the number of shares outstanding. A P/B ratio under 1.0 might suggest a heavily undervalued stock—or a company with serious problems.

• Typical Applications

1. Financial and Asset-Intensive Industries: For banks or real estate companies, the balance sheet is central to how they operate and generate profits.
2. Evaluating Distressed or Liquidation Scenarios: The P/B ratio can highlight whether the market believes the firm’s assets are overstated or underappreciated.
3. Intangible Assets: Firms with large intangible assets (e.g., brand names, patents) might be misleadingly undervalued on a book-value basis because intangible assets often aren’t fully captured on the balance sheet under certain accounting standards.

Price-to-Sales (P/S) Ratio

• Formula:

This ratio is often used for companies that lack robust earnings—for instance, early-stage firms or cyclical players in a downturn.

• Why Analysts Love P/S

1. Less Manipulation: Sales are typically harder to manipulate compared to earnings.
2. Valuing Startups: Newer companies might have negative or negligible earnings, so P/E is meaningless but P/S can provide a starting point.
3. Industry Benchmarks: Sectors like software-as-a-service (SaaS) are sometimes valued on multiples of revenue because the market expects high future growth.

However, watch out if a company’s sales are artificially inflated by promotions or if it’s failing to manage costs. A high P/S alone isn’t always a sign of overvaluation if the company’s growth prospects are exceptional.

EV/EBITDA (Enterprise Value–to–EBITDA)

• Formula:

Enterprise Value (EV) is calculated as:

EBITDA is a proxy for operating cash flow. Thus, EV/EBITDA measures the overall firm value (debt + equity) relative to the core operating income (EBITDA).

• Key Advantages

1. Accounts for Different Capital Structures: Because EV includes debt, two companies with different financing approaches can be more accurately compared.
2. Minimizes Accounting Distortions: EBITDA strips out depreciation and amortization, making cross-comparison among capital-intensive industries a bit easier.
3. M&A Context: In takeover scenarios, buyers often assume the target’s debt, so EV/EBITDA is a common approach.

• Cautions

1. Ignores Capital Expenditures: Depreciation is excluded, so you might underestimate the effect of heavy future capital spending.
2. Potential Overstatement of Operating Cash Flow: EBITDA is not identical to free cash flow.

The Mechanism of Relative Valuation

Relative valuation involves contrasting a chosen ratio (e.g., P/E) against an appropriate benchmark such as:
• Peer group averages
• Sector or industry indexes
• Overall market indexes
• The company’s own historical multiples

If a firm’s P/E is 15 while the industry average is 20, you might suspect it’s undervalued—unless the firm has structural issues justifying the discount. Always ask why a multiple is higher or lower.

In practice, analysts build “comparable company” lists to gauge the average or median multiple across a relevant peer set. Then they’ll either:

1. Compare the target firm’s ratio to the group’s.
2. Calculate implied values by applying the average multiple to the target’s fundamentals (e.g., EPS or EBITDA).

Ensuring Apples-to-Apples Comparisons

Remember that not all earnings are created equal. Differences in accounting standards (IFRS vs. U.S. GAAP), revenue recognition, or intangible asset treatments can distort the multiples. Here are a few things to watch out for:

1. Consistent EPS Calculation: Is the EPS diluted? Are one-time charges excluded?
2. Adjust for Off-Balance-Sheet Items: Operating leases, pensions, or intangible assets can significantly change the effective book value or enterprise value.
3. Capital Structure Differences: If one company used mostly debt to finance growth and another primarily used equity, you need to consider the added leverage.

Strengths and Limitations of Price Multiples

Strengths

• Quick Snapshot: Rapidly gives you a sense of valuation for screening or quick checks.
• Easy to Convey: Easy to explain to clients or executives, “This stock trades at 12 times earnings.”
• Broad Market Acceptance: Commonly used across industries, so you’ll find plenty of comparable data.

Limitations

• Oversimplification: A single ratio can’t capture a company’s complexities, such as strategic moats, intangible assets, or cyclical fluctuations.
• Can Be Influenced by Non-Recurring Items: M&A gains, write-offs, or tax credits can distort earnings-based multiples.
• Sensitive to Shifts in Growth Expectations: Multiples can drastically expand or contract when market sentiment changes.

Practical Example: Building a Comparable Company Analysis

Let’s try a simple, hypothetical scenario:

• Your company, Alpha Corp, has:

• Stock price: $50
• EPS: $5
• Book value per share: $40
• Sales per share: $80
• EBITDA (annual) per share: $10 (assuming 100 shares outstanding, total EBITDA = $1,000)
• Debt: $2,000
• Cash: $500
• Market cap: $5,000 (i.e., price $50 × 100 shares)

• Calculate the following:

1. P/E = 50 / 5 = 10
2. P/B = 50 / 40 = 1.25
3. P/S = 50 / 80 = 0.625
4. EV = 5,000 + 2,000 – 500 = $6,500
5. EV/EBITDA = 6,500 / 1,000 = 6.5

Next, gather the same info from Beta Corp and Gamma Corp—two close peers of Alpha. Suppose the industry average P/E is 12, and EV/EBITDA is 7. Then you might conclude Alpha trades slightly below the industry average. Is that because investors are missing something, or do they see slower future growth? That’s the essential detective work of equity analysis.

Exam Relevance and Tips

From the CFA exam perspective, especially at Level I (and across subsequent levels), you’re expected to:

• Know how to calculate each multiple quickly.
• Recognize when one multiple is more appropriate than another.
• Discuss the limitations of each multiple (e.g., negative earnings complicate P/E).
• Apply relative valuation to assess if a stock is over- or undervalued compared to peers.
• Understand how different accounting treatments or capital structures can affect multiples.

When confronted with a constructed-response question or an item set, be ready to:

1. Perform computations under time pressure (e.g., “Calculate the EV/EBITDA for each firm and compare to an industry average.”)
2. Interpret the results with reference to the firm’s fundamentals.
3. Consider adjustments for non-recurring items or differences in accounting.

Pro tip for exam day: If you notice multiple choice answers with a suspiciously big difference in price multiples, double-check the numerator (market price, EV) or denominator (EPS, EBITDA) for potential changes from non-core items. Don’t forget to see if the problem statement indicates share buybacks or new equity issuance that might alter the share count.

Best Practices and Potential Pitfalls

• Look Beyond the Ratio: If a P/E ratio looks oddly low, investigate the company’s recent earnings. Are they sustainable?
• Combine Multiples: Emphasize more than one ratio for a holistic view—e.g., P/E plus EV/EBITDA.
• Adjust for Growth Rates: A high multiple might be justified by robust growth, so focus on forward expectations.
• Beware Cyclical Industries: Earnings can swing wildly (e.g., energy, airlines, commodities). In these cases, trailing P/E might be misleading; you might prefer an average of normalized earnings.
• Holistic Industry Perspective: Compare with carefully chosen peers. A single outlier peer can skew the average drastically.

References

• CFA Institute, “Financial Statement Analysis”
• Koller, Tim, et al. Valuation: Measuring and Managing the Value of Companies. McKinsey & Company.
• Graham, Benjamin, and David Dodd. Security Analysis.
• IFRS and U.S. GAAP guidelines on financial statement presentation.

Final Thoughts

Just like you wouldn’t buy a pair of shoes based solely on size without checking comfort or style, you shouldn’t bet everything on a single price multiple. Sure, they’re an indispensable part of the valuation toolbox, but complement them with a deep dive into the company’s fundamentals, industry position, and future growth prospects. And if one ratio is telling a drastically different story from the others, well, there’s the sign you should investigate a little more.

Keep practicing. The more you navigate real-world (and hypothetical) scenarios, the better you’ll be at picking the right multiples and interpreting them accurately. Good luck!

Test Your Knowledge: Price Multiples and Relative Valuation