Module 3 · Multiples & Ratios Foundation

Multiples are the fast way to value a stock — and the fast way to fool yourself. This module teaches every ratio that matters, which company each one fits, and the traps that turn a “cheap” number into a loss.

P/E: the price of a dollar of earnings

The price-to-earnings ratio is the most quoted multiple in investing:

Read it literally: a P/E of 20 means the market will pay $20 today for each $1 the company earned last year. Flip it over and you get the earnings yield — 1 ÷ P/E — which for a 20× stock is 5%, directly comparable to a bond yield.

Trailing P/E uses the last twelve months of reported earnings; forward P/E uses analysts' estimate of next year's. Forward P/E is lower for a growing company but leans on forecasts that can miss. And P/E breaks entirely for money-losers: a negative denominator makes the ratio meaningless, which is why loss-making growth needs the tools in Module 9.

PEG: growth-adjusting the P/E

A P/E of 30 sounds expensive until you learn the company is growing earnings 30% a year. Peter Lynch popularised the PEG ratio to capture that:

Lynch's rule of thumb: a PEG near 1.0 is roughly fair, below 1.0 potentially cheap, above 2.0 getting expensive. It's a useful gut-check, but it's abused constantly — plug in a heroic growth estimate and any stock looks cheap. Use conservative, defensible growth, and never lean on PEG alone. (A sane PEG implementation clamps the implied fair P/E to a band like 8–30 for exactly this reason.)

EV/EBITDA: comparing across capital structures

P/E is distorted by debt, because interest is subtracted before earnings. EV/EBITDA fixes that by comparing enterprise value (which includes debt) to earnings before interest, tax, depreciation and amortisation:

Because both numerator and denominator sit “above” financing, two companies with very different debt loads become comparable. The catch: EBITDA adds back depreciation, but capital-heavy businesses — pipelines, telecoms, cable — must keep spending real cash on CapEx just to stand still. For them, EBITDA is not cash flow, and EV/EBITDA can flatter a business that's quietly consuming capital.

P/B: still matters for financials

The price-to-book ratio compares price to accounting net worth. For most modern companies it's nearly useless — a software firm's value is its people and code, which never touch the balance sheet. But for banks, insurers and other asset-heavy financials, book value closely tracks real economic assets, so P/B (and its cousin price-to-tangible-book) is a core tool. We return to it in Module 9.

P/S and EV/Sales: valuing the pre-profit

When a company has no earnings yet, revenue is the only anchor. Price-to-sales and EV/Sales let you value fast growers — but with extreme care. Scott McNealy, then CEO of Sun Microsystems, famously mocked investors who paid 10× sales for his stock: at that price, he pointed out, they were assuming the company would hand over all its revenue for ten years with zero costs, zero taxes and zero reinvestment — impossible. A high sales multiple embeds heroic assumptions; make them explicit before you pay it.

P/FCF: the quality investor's P/E

Because free cash flow (Module 2) is much harder to massage than accounting earnings, price-to-free-cash-flow is often a cleaner quality gauge than P/E. A company whose P/E looks fine but whose P/FCF looks awful is converting little of its “profit” into actual cash — a flag worth chasing down.

The cardinal rule: relative to what?

Here is the rule that separates people who use multiples well from people who lose money with them. A multiple is meaningless in isolation. A P/E of 12 is cheap or dear only relative to three things:

1. The company's own history — is 12× low or high for this business?
2. Sector peers — do comparable companies trade higher or lower?
3. Growth and quality — a slow, low-quality business deserves a low multiple.

The corollary is the trap that catches every beginner: a low P/E can be a value trap, and a high P/E can be cheap. The market usually has a reason for a bargain multiple — a shrinking business, a legal cloud, a cyclical peak about to roll over. A low number is the beginning of an investigation, never the end of one.

Sector norms

Every sector has a characteristic range. Committing the rough shape to memory stops you calling a bank “cheap” at 20× or a software firm “expensive” at 20×. These medians are illustrative and shift over time, so re-check them against current data before you lean on any peer comparison.