Two chemical producers trade at price-to-earnings ratios of 12 and 25. Nothing about that pair tells you which is cheap until you know what each one earns on equity, how fast it grows, and what risk you bear holding it.
A price multiple divides a stock's market price by a per-share measure of value: earnings, book value, sales, cash flow, or dividends. An enterprise value multiple divides the market value of all capital claims by a measure of value belonging to all capital providers, such as earnings before interest, taxes, depreciation, and amortization (EBITDA). Both compress a valuation into one number, which is why they dominate practitioner communication.
Analysts reach a multiple by two routes.
- Method of comparables: benchmark the subject's multiple against similar assets, a peer median, an industry, a sector, an index, or the company's own historical average.
- Method based on forecasted fundamentals: derive the multiple from a discounted cash flow (DCF) or residual income model, because fundamentals (profitability, growth, financial strength) drive cash flows and cash flows...
Common mistakes
- Averaging multiples arithmetically. With peers at 7.2, 9.0, 11.5, and 6.5, the arithmetic mean 8.55 overstates the harmonic mean 8.15 and can flip a verdict from cheap to expensive.
- Multiplying the forward benchmark by the wrong earnings. Terminal value uses but . Applying the forward multiple to understates here by roughly one year of growth.
- Pairing price with EBITDA. EBITDA is pre-interest and belongs to debt and equity holders together, so it must sit under enterprise value, never under equity price alone.
Bottom line
- Two methods: comparables (rationale is the law of one price, gives relative value) and forecasted fundamentals (rationale is DCF, gives absolute value); a justified multiple is the fair value of the multiple under either
- Justified forward P/E = (1−b)/(r−g); trailing P/E = (1−b)(1+g)/(r−g); P/B = (ROE−g)/(r−g); P/S = (E0/S0)(1−b)(1+g)/(r−g); D0/P0 = (r−g)/(1+g)
- Normalizing EPS: historical average EPS over the full cycle, or average cycle ROE × current book value per share (preferred when size changed)
- Underlying earnings strip nonrecurring items; company-reported core earnings follow no rules and are not comparable
Exam shortcut
Read the stem for which route is wanted. "Relative to peers," "industry median," or "guideline companies" means comparables and the answer is a verdict, not a price. "Based on forecasted fundamentals" means plug into a justified formula. When the vignette hands you ROE and retention, compute first; nearly every justified formula needs it, and the trap answer omits the that separates trailing from forward.
The full lesson (about 3,976 words, 27 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- market based valuation
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