How do you know if a stock is expensive? Not from the share price — a $500 stock can be cheap and a $5 stock dear. Multiples answer the question properly by comparing a company’s price to a fundamental it produces: earnings, cash flow, or book value. They’re the lingua franca of Wall Street (“it trades at 18 times earnings”) and the fastest way to compare companies — but each multiple has a blind spot, and a multiple in isolation is a half-told story. This lesson teaches the big three (P/E, EV/EBITDA, P/B), when to trust each, and the traps that catch the unwary.
Before you read — take a guess
Guess before reading. Company A trades at $200 per share and Company B at $20. Which is more expensive?
Relative vs absolute valuation
Multiples are relative valuation: they tell you what a company is worth compared to its peers or its own history, not its intrinsic worth in a vacuum. The next lesson covers absolute valuation — a discounted cash flow that estimates worth from scratch. Multiples are faster and market-anchored; DCF is deeper and assumption-driven. Pros use both and triangulate.
The P/E ratio — price per dollar of earnings
Analogy. Imagine buying a lemonade stand that earns $10,000 a year. If the seller asks $100,000, you’re paying 10 times annual earnings — it’d take 10 years of profit to earn your money back (ignoring growth). Ask $300,000 and that’s 30 times earnings — pricier, justified only if profits will grow fast. The price-to-earnings ratio is exactly this multiple, applied to a share.
Definition.
The P/E says how many dollars investors pay for one dollar of annual profit. A high P/E means the market expects strong growth (or the stock is overpriced); a low P/E means modest expectations (or a bargain — or a value trap).
Worked example. A stock at $60 with EPS of $3 has a P/E of 60 / 3 = 20. Investors pay $20 for each $1 of current annual earnings. Equivalently, the earnings yield — the inverse — is 1 / 20 = 5%: the company earns 5 cents of profit per dollar you invest, a number you can directly compare to bond yields.
Trailing vs forward P/E. Trailing P/E uses the last 12 months of earnings (a fact); forward P/E uses projected earnings (a forecast). A high trailing P/E that becomes a reasonable forward P/E signals expected growth — the market is pricing tomorrow’s bigger earnings, not today’s.
Misconception. “A low P/E always means a cheap, good buy.” The most expensive mistake in investing. A low P/E can mean the market expects earnings to collapse — a struggling retailer at a P/E of 6 may be cheap for an excellent reason (a value trap). And P/E breaks entirely for companies with negative earnings (no meaningful ratio) and is distorted by one-off items in net income. A low P/E is a question, not an answer.
Think first
Two software companies look identical, but one trades at a P/E of 15 and the other at 40. Before concluding the P/E-40 stock is 'overpriced,' what should you check? Think, then reveal.
Hint: P/E embeds expected growth. What else differs between two superficially similar firms?
Enterprise value — the price of the whole business
Analogy. You’re buying a house listed at $400,000, but it comes with a $300,000 mortgage you must assume and $50,000 of cash hidden in the walls. The true cost of owning the house outright is $400,000 + $300,000 − $50,000 = $650,000. Market cap is just the listing price; enterprise value is the all-in cost of acquiring the whole business, debt and cash included.
Definition. Enterprise value (EV) is what it would cost to buy the entire company free and clear:
You add debt (an acquirer inherits it and must repay it) and subtract cash (which the acquirer gets, offsetting the price). EV is the capital-structure-neutral price tag: it values the underlying business regardless of how it’s financed.
Worked example. A company has a $1,000M market cap, $400M of debt, and $100M of cash:
Two companies can share a $1,000M market cap but have wildly different enterprise values: a debt-free, cash-rich firm might have an EV of $800M, while a debt-laden one has an EV of $1,500M. Market cap alone hides this; EV exposes it. This is why P/E (which uses market cap and ignores debt) can mislead when comparing companies with different leverage.
Two companies each have a market cap of $500M and identical operating profits. Company A has $300M of net debt; Company B has $200M of net cash. Which is genuinely cheaper to acquire?
EV/EBITDA — the capital-structure-neutral workhorse
Definition. Pair enterprise value with EBITDA (operating cash earnings before interest, tax, depreciation and amortization) and you get the most widely used multiple in deal-making:
Why it’s beloved: the numerator (EV) is neutral to how the company is financed, and the denominator (EBITDA) is neutral to capital structure and non-cash charges — so EV/EBITDA compares the raw operating engines of two companies even if one is debt-free and the other leveraged, one in a high-tax country and the other not. It’s the great equaliser for cross-company and cross-border comparison.
Worked example. EV $1,300M, EBITDA $170M → EV/EBITDA = 1,300 / 170 ≈ 7.6×. A peer at $1,000M EV and $100M EBITDA trades at 10×. On this yardstick, the first company is cheaper per dollar of operating earnings — even if their P/E ratios (which are tangled up with different debt loads) suggested otherwise.
Misconception. “EV/EBITDA is the one true multiple — it fixes all of P/E’s problems.” It fixes some, but EBITDA’s blind spot is the one you met earlier: it adds back depreciation, pretending the cost of replacing worn-out assets doesn’t exist. For capital-light software, that’s fine; for capital-heavy airlines, telecoms or manufacturers, EV/EBITDA flatters companies that must constantly spend to stand still. For those, EV/EBIT (which keeps depreciation as a cost) or a free-cash-flow multiple is fairer. No multiple is universal.
Price-to-book — price per dollar of net worth
Definition. The price-to-book ratio compares market price to the accounting book value (equity) you met in the balance-sheet lesson:
A P/B of 1 means the market values the company at exactly its accounting net worth; above 1, the market sees value the books don’t record (brand, growth, intangibles); below 1, the market values the company at less than its stated net worth — a sign of distress, doubted asset values, or a genuine bargain.
Worked example. A bank with a $3,000M market cap and $2,000M of book equity trades at P/B = 1.5. P/B is especially meaningful for financial firms (banks, insurers), whose assets are mostly financial instruments carried near market value — so book value is a reasonably real number. It’s far less useful for asset-light firms (a software company’s book value is almost meaningless), where most value is intangible and uncaptured.
The value factor lives here
Price-to-book is the foundation of the academic value factor — the long-run tendency of low-P/B (“value”) stocks to outperform high-P/B (“growth”) stocks. When the factor-models course speaks of “book-to-market” (just P/B flipped upside down), this is the ratio it means. Reading a balance sheet for book value is what makes that whole factor computable.
P/E: Price ÷ earnings per share — what you pay for each unit of profit. Ignores debt.
A company can look cheap on one multiple and expensive on another. Always ask which yardstick a "cheap" claim is using — and whether it accounts for debt and growth.
The PEG ratio — adjusting P/E for growth
Definition. A raw P/E ignores growth, so the PEG ratio divides it by the earnings growth rate (in percentage points) to compare companies growing at different speeds:
A rough rule of thumb (popularised by Peter Lynch): PEG around 1 is fairly priced, below 1 is potentially cheap given the growth, above 1 may be expensive. It’s a quick way to see whether a scary-looking P/E is justified by the growth behind it.
Worked example. A stock with a P/E of 30 growing earnings at 30% a year has a PEG of 30 / 30 = 1.0 — fairly priced despite the high P/E. A stock with a P/E of 12 growing at only 4% has a PEG of 12 / 4 = 3.0 — arguably more expensive than the high-P/E growth stock, once you account for growth. The “cheap” low-P/E stock is the dearer one on a growth-adjusted basis.
Misconception. “PEG below 1 is a guaranteed bargain.” PEG leans entirely on the growth estimate, which is a forecast — and forecasts for fast growers are notoriously optimistic. A PEG of 0.7 built on a fantasy 40% growth rate is worthless. PEG is a useful sanity check, not a precision instrument; garbage growth assumptions in, garbage PEG out.
Sort each statement about multiples as True or a Trap (a common mistake).
Sort each statement as True or a Trap.
- Enterprise value adds debt and subtracts cash from market cap
- EV/EBITDA is perfect for capital-heavy airlines because it ignores asset replacement
- EV/EBITDA is capital-structure-neutral, so it compares leveraged and debt-free firms fairly
- P/B is most meaningful for banks and insurers, less so for software firms
- A high share price means a stock is expensive
- PEG below 1 guarantees a bargain regardless of the growth forecast
- A low P/E always means a stock is cheap and a good buy
Lock in the multiples vocabulary.
Pick the right option for each blank and check.
The P/E ratio equals price divided by ; its inverse, the earnings yield, is comparable to a bond yield. Enterprise value equals market cap plus debt . is capital-structure-neutral, making it ideal for comparing firms with different debt loads. Price-to-book is most useful for , whose assets sit near market value on the balance sheet.
Big picture
The valuation multiples toolkit
- Valuation Multiples
- P/E = price / EPS
- Earnings yield = 1 / P/E (compare to bond yields)
- Ignores debt; breaks for negative earnings
- Low P/E can be a value trap
- Enterprise value = mkt cap + debt − cash
- The all-in cost of the whole business
- EV/EBITDA
- Capital-structure-neutral workhorse
- Flatters capital-heavy firms (ignores capex)
- P/B = price / book value
- Best for banks/insurers; weak for asset-light firms
- Foundation of the value factor (book-to-market)
- PEG = P/E / growth
- Adjusts P/E for growth; only as good as the forecast
- P/E = price / EPS
A mixed recap pulling from the whole lesson:
A stock trades at $80 with trailing EPS of $4. What is its P/E and its earnings yield?
Check your answer to continue.
Key Takeaways
What to remember
- Share price alone is meaningless — multiples compare price to a fundamental (earnings, cash, book value) to judge whether a stock is expensive.
- P/E = price / EPS measures dollars paid per dollar of profit; its inverse is the earnings yield. A low P/E can be a bargain or a value trap, and it breaks for negative earnings.
- Enterprise value = market cap + debt − cash is the all-in price of the whole business — the right basis when comparing firms with different leverage.
- EV/EBITDA is the capital-structure-neutral workhorse, fair across debt loads and tax regimes — but it flatters capital-heavy firms by ignoring the cost of replacing worn-out assets.
- Price-to-book shines for banks and insurers (real asset values) and underpins the value factor; it’s weak for asset-light firms.
- The PEG ratio adjusts P/E for growth — a useful sanity check, but only as trustworthy as the growth forecast behind it. No single multiple is universal; match the tool to the company and triangulate.