Valuation multiples and their traps
A multiple is shorthand for expectations. It is a question generator, never a verdict on cheap or expensive.
What a multiple compresses
The price-to-earnings ratio divides price per share by earnings per share. A P/E of 20 means investors pay $20 for each $1 of current annual earnings. Inverted, it is a 5% earnings yield on today's profit.
Baked into that single number are growth expectations, perceived risk, capital intensity, and interest rates. Two companies with identical P/Es can carry entirely different implied futures.
Choosing the right multiple
EV/EBITDA uses enterprise value and pre-interest profit, making it more comparable across companies with different debt loads. Price-to-sales is a last resort for unprofitable firms, and it silently assumes future margins you should state out loud.
Compare like with like: same industry, similar accounting, similar point in the cycle.
Cheap for a reason
A low multiple can mean the market expects earnings to fall. Buying a cyclical at peak earnings on a 6x P/E can be far more expensive than it looks once earnings normalise. That is the classic value trap.
Worked example
The cyclical peak illusion
- A shipping company earns $10 EPS in a boom year; the share price is $60, so P/E = 6. It looks cheap.
- Mid-cycle average earnings over the last decade are $2.50 EPS.
- On normalised earnings the multiple is $60 / $2.50 = 24x.
- If earnings revert to $2.50 and the market applies a 12x multiple, the share is worth about $30 — a 50% decline.
Always ask which earnings are in the denominator: peak, trough, or normalised. The multiple is only as meaningful as that number.
Common misconceptions
“A low P/E means a stock is cheap.”
It often means the market expects earnings to fall, or that risk is high. Low multiples require an explanation.
“A high P/E means a stock is overvalued.”
Durable high growth can justify a high multiple. The question is whether the growth actually arrives.
Checkpoint