Valuation: multiples

In short

You have probably looked at a stock price and wondered whether it was cheap or expensive. That is a fair thing to wonder. A valuation multiple is just a ratio, a comparison between what you pay and what you get. It does not tell you what to do. It tells you what the market is currently willing to pay per dollar of something, like earnings or sales. Five sentences and you have the idea. Learn the ratio, find the number, then think hard about what it means for your own situation.

The whole of it

What it is

A friend of mine once bought a used truck. He paid twice what a neighbor paid for a nearly identical one. Both trucks ran fine. The difference was not the truck. It was the price he agreed to. A valuation multiple works the same way. It measures how much you are paying for each unit of a company's financial output. The most common unit is earnings, meaning the profit the company keeps after expenses. The ratio that uses earnings is called the price to earnings ratio, or P/E. You divide the share price by the earnings per share. That gives you a single number. That number tells you how many dollars the market pays for each dollar of profit. Other multiples use sales, cash flow, or book value, meaning the accounting value of the company's assets minus its debts. Each ratio is a different lens. None of them is the whole picture.

How it works

I once watched a careful man spend an hour comparing two nearly identical tools at a hardware store. He read every label. He compared price per use. He was doing, without knowing it, exactly what a valuation multiple does. The multiple strips a company down to one comparison. Take the P/E ratio. If a share costs 40 dollars and the company earns 2 dollars per share, the P/E is 20. That means the market pays 20 dollars for every 1 dollar of annual profit. A higher P/E can mean investors expect faster growth ahead. It can also mean the stock is priced for perfection and any bad news hits hard. A lower P/E can mean a bargain. It can also mean the business is struggling and the low price is deserved. The ratio does not judge. You do the judging.

The price to sales ratio, or P/S, divides share price by revenue per share. Revenue is the money coming in before expenses. Useful when a company has no earnings yet. The price to book ratio, or P/B, divides share price by book value per share. Useful for banks and financial companies where assets matter a great deal. The enterprise value to EBITDA ratio, often written EV/EBITDA, compares the total value of the business, including its debt, to its earnings before interest, taxes, depreciation, and amortization. Depreciation means the gradual loss in value of physical assets over time. Amortization means the same thing but for intangible assets, like a patent. EV/EBITDA is useful when comparing companies that carry very different amounts of debt. Each of these is a tool. No single tool builds the whole house.

The numbers, and where to find yours

You have probably seen a P/E ratio printed right on a brokerage page without knowing exactly what fed into it. Two versions of the P/E are common. The trailing P/E uses actual earnings from the past twelve months. The forward P/E uses analyst estimates of future earnings. Estimates can be wrong. The trailing number is what really happened. Neither is superior in every case. Both are worth checking.

No law sets a correct P/E. That is the honest truth. What changes by law is unrelated to multiples directly, but if you are using a tax advantaged account to hold stocks, the contribution limits for those accounts are set each year by the IRS. You can find the current figures on the official IRS website at irs.gov. For broader market valuation data, the Federal Reserve publishes the Financial Accounts of the United States, available at federalreserve.gov. Robert Shiller at Yale publishes his long run CAPE data, which stands for cyclically adjusted price to earnings and smooths earnings over ten years, at his faculty page at yale.edu. That data goes back over a century. The SEC requires public companies to file earnings data through EDGAR, available at sec.gov. Those are the primary sources. They do not charge you anything.

A worked example

Maria earns 52,000 dollars a year and saves carefully. She is looking at two companies. Call them Company A and Company B. Company A trades at 30 dollars per share. It earned 1 dollar and 50 cents per share last year. Divide 30 by 1.50 and you get a P/E of 20. Company B trades at 30 dollars per share too. It earned 3 dollars per share last year. Divide 30 by 3 and you get a P/E of 10. Same price. Very different story. Company B looks cheaper by this one measure. Maria does not stop there. She checks the P/S ratio for both. Company A has annual sales of 5 dollars per share. Its P/S is 6. Company B has annual sales of 15 dollars per share. Its P/S is 2. Company B looks cheaper on that measure too. But Maria also reads the filings on EDGAR. She learns Company A is growing revenue at 3 percent of its sales base each year and Company B has been shrinking. A low multiple on a shrinking business is not necessarily a gift. Maria leaves with better questions, not a final answer. That is exactly the right place to land.

Where it goes wrong

I once knew a fellow who thought anything cheap was a good deal. He filled his barn with cheap things that never worked. Cheap is not the same as good value. A low multiple on a company with falling earnings can keep falling. Earnings can be manipulated through accounting choices. A company can borrow money to buy back shares, which reduces the share count and makes earnings per share look higher even if total profit did not grow. That is worth knowing. The forward P/E depends entirely on estimates that may not come true. Comparing a P/E from a technology company to one from a utility company can mislead you. Different industries carry different normal ranges. Sector matters. Timing matters. The economy matters. A multiple is a starting point. Full stop.

Questions to answer before you leave this page

If you are sitting with a stock in mind right now, ask yourself whether you know which version of the P/E you are looking at, whether it is trailing or forward, and whether you have checked the source of the earnings figure, and then ask whether you have compared that multiple to other companies in the same industry rather than to companies in totally different businesses, and ask whether the earnings in the denominator look stable or whether they bounced around a lot from year to year, and ask what you would need to believe about that company's future for the current multiple to feel reasonable, and ask whether you have read at least the summary of the company's most recent annual filing on EDGAR at sec.gov before making any judgment, and finally ask yourself whether you are comfortable with the idea that even a perfectly calculated multiple does not remove uncertainty, because it does not, and no ratio ever will, and that is not a flaw in the tool, it is just an honest fact about how markets work.