A peer multiple gives you a fast cross-check on intrinsic value, but only if the peer set is comparable and the multiple is appropriate to the firm's economics.
Relative valuation says one company should trade at a price consistent with how the market prices comparable economics elsewhere. There are two ways to operationalize this.
Method of comparables. Pick a peer group, calculate the average or median multiple, and apply it to the target's per-share metric. If peers trade at a 15x price-to-earnings (P/E) ratio and your target's earnings per share (EPS) are $4, the implied price is $60. The market does the valuation work; you are arbitraging mispricing within a peer set.
Method of forecasted fundamentals. Derive what the multiple should be from a discounted cash flow or dividend discount model (DDM). The Gordon growth justified P/E is the canonical example. Start from the Gordon model, P0 = D1 / (r − g), and divide both sides by next year's earnings, E1.
Common mistakes
- Equating low P/E with cheapness. A low multiple often reflects low growth, high risk, or impending earnings decline. Trap: ranking firms by P/E and recommending the lowest as undervalued without examining drivers.
- Using P/E on firms with negative or depressed earnings. P/E is undefined or meaningless when EPS is zero, negative, or at a cyclical trough. Use P/E on normalized (mid-cycle) EPS, or P/S, P/B, or EV/Sales, instead. Trap: reading Cobalt's 120x P/E as expensive when P/B, P/S, and P/CF all say it is cheap.
- Comparing P/E across firms with different leverage. Capital structure distorts P/E because interest expense flows through earnings. Use EV/EBITDA when leverage differs materially. Trap: concluding the more levered firm is cheaper based on P/E alone.
Bottom line
- Method of comparables benchmarks against peers. Method of forecasted fundamentals derives a justified multiple from a discounted cash flow (DCF) or DDM model. Best practice uses both.
- Price multiples (P/E, P/B, P/S, P/CF) value equity directly. Enterprise value multiples (EV/EBITDA, EV/Sales, EV/EBIT, EV/FCFF) value the whole firm and work across capital structures.
- Trailing (TTM) uses last four quarters. Current uses most recent fiscal year. Forward uses next-12-months estimates.
- Peer group: same GICS or ICB classification PLUS similar growth, margins, risk, and capital intensity. Industry code alone is not enough.
Exam shortcut
For peer-group questions, remember "industry code gets you the universe; driver similarity gets you the peer group." For capital-structure-mixed comparisons, default to EV/EBITDA over P/E. For the Gordon justified P/E, memorize the leading form: payout / (r − g); the trailing form multiplies that by (1 + g).
The full lesson (about 4,158 words, 28 min read) adds 10 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- relative value valuation
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