P/E and Valuation Multiples

Knowing a company's profit is only half the puzzle. The other half is what the market is willing to pay for that profit. Valuation multiples connect price to the fundamentals you have been learning, and the price-to-earnings ratio is the most famous of them all. Multiples are the quick, comparative language of valuation, and they use the EPS you just calculated as a key ingredient.

The price-to-earnings ratio

The P/E ratio is the share price divided by earnings per share. It tells you how many dollars investors are paying for each dollar of a company's annual earnings. A P/E of 20 means investors pay 20 dollars for every 1 dollar of yearly profit. By itself that number is neither good nor bad. Its meaning comes entirely from comparison, against peers, against the company's own history, or against the overall market.

Trailing versus forward

• Trailing P/E uses actual earnings from the past twelve months, a backward-looking fact.
• Forward P/E uses analysts' estimated earnings for the coming year, a forward-looking expectation.
• The two can differ sharply for companies whose profits are expected to change quickly.

What a high or low P/E signals

A high P/E usually means the market expects strong future growth and is willing to pay up for it, though it can also mean the stock is overvalued. A low P/E can mean the market expects little growth or trouble ahead, or that the stock is undervalued and overlooked, which is the hunting ground of value investors. The ratio squeezes growth expectations and risk into a single number. That compression is both its power and its danger.

A multiple is the market's opinion in one number. Reading it well means asking what the market is assuming, and whether it is right.

Other multiples in the toolkit

• Price-to-sales (P/S): price relative to revenue, useful for companies with little or no profit yet.
• Price-to-book (P/B): price relative to net asset value, common for banks and asset-heavy firms.
• EV/EBITDA: enterprise value relative to EBITDA, which accounts for debt and is popular for comparing across capital structures.
• PEG ratio: P/E divided by the earnings growth rate, an attempt to put growth and value in one figure.

The limits of multiples

Multiples are relative valuation. They only mean something against peers, the company's own history, or the broader market. They break down when earnings are negative or distorted, and a single multiple says nothing about why a company is cheap or expensive. That is why multiples are a starting point, not a conclusion, and why the intrinsic-valuation methods of Unit 3 exist to answer the deeper question of what a business is actually worth.

You can now put a price on earnings. Next we measure how efficiently a company turns its capital into those earnings, using the return ratios ROE and ROA.