Valuation ratios

Two companies trade on the same price-to-earnings multiple of twenty. On any screen sorted by P/E they are equally valued, equally "expensive." But one grows its earnings at five percent a year and the other at twenty-five. In a few years the fast-grower's earnings will have multiplied while the slow-grower's have barely moved - so paying twenty times for one is dear and paying the same twenty times for the other can be a bargain. The multiple was identical; the value could hardly be more different. illustrative

A valuation ratio is the most compressed number in all of analysis, because it folds two things together: the price the market is paying, and - buried inside that price - everything the market expects. A P/E of twenty is not just "twenty rupees of price per rupee of earnings"; it is a statement that the market expects those earnings to grow, and to be real, and to last, enough to justify twenty. So a multiple is never simply high or low; it is high or low relative to what must come true to deserve it. This module walks the family - P/E, EV/EBITDA, price-to-book, price-to-sales, free-cash-flow yield - what each one assumes, when each is the right tool and when it goes dark, and how to read every one as a statement of expectations rather than a verdict on cheapness.

Every valuation multiple divides what you pay by some measure of what you get. But there are several measures of "what you get," and each choice smuggles in an assumption that can be right or wrong for the business in front of you. Pick the numerator, pick the denominator, and the pairing has already decided which businesses it fits and which it will lie about.

Price versus enterprise value is the first fork, and it decides what you are valuing. A price-based multiple - P/E, P/B, P/S - values the equity, the owners' slice. An enterprise-value multiple - EV/EBITDA, EV/EBIT - values the whole firm, because enterprise value is market cap plus net debt, and it is paired with a profit measured before interest. The working rule: when two businesses carry very different debt, reach for the enterprise-value multiples, because P/E is contaminated by financing. A heavily-indebted firm's earnings are struck after heavy interest, so its P/E reflects its balance sheet as much as its business; enterprise value adds the debt back and prices the operation on the same basis whatever its leverage. When leverage is similar, P/E is simpler and fine.

Match the denominator to the business. Earnings (P/E) work for a stable, profitable firm whose earnings actually mean something. EBITDA-based multiples suit capital-heavy operators where you want to compare operating cash generation before differing depreciation and financing - but EBITDA flatters an asset-heavy firm by ignoring the depreciation that is a genuine economic cost, so EV/EBIT, which charges that depreciation, is often the truer measure for a business that really consumes its assets. Book value (P/B) is the anchor where the balance sheet is the business - a bank, an insurer - and it must always be read against ROE: a lender earning 18% on equity deserves a higher P/B than one earning 8%. Sales (P/S) is a last resort for firms with no earnings yet, and dangerous precisely because sales say nothing about whether those sales will ever be profitable. And free-cash-flow yield turns the whole thing around - free cash flow divided by market value - to ask the most honest question of the lot: what cash return is this business actually throwing off for its price? It comes closest to the owner's real question - the cash you could take out per rupee paid - which is why it resists the accounting choices that flatter the others.

Then read the expectation, not the level. A multiple's level is meaningless without the growth, quality and durability it is pricing. The PEG idea makes this explicit for P/E - a P/E of 30 on 30% growth (PEG of 1) is a different animal from a P/E of 30 on 8% growth (PEG near 4) - but the same principle runs through the whole family. A high EV/EBITDA prices in years of growing cash flow; a low price-to-book prices in a return on equity the market does not believe will hold. So the question is never "is this multiple high or low?" It is "what does this multiple require the business to deliver, and is that likely?" A high multiple is a high bar the company has now promised, on your behalf, to clear.

Which multiple to reach for is set almost entirely by the sector, and this is the module's real lesson: the same multiple that anchors one business is a category error for the next. Import the wrong one and it does not merely mislead - it produces a confident, precise, useless number. Four businesses, and the multiple each is properly valued on.

Look at what inverts. For a bank, enterprise value is a category error, so price-to-book against ROE is the only sensible anchor - the multiple you would never quote for a factory is the one you must use here. For a capital-heavy operator the enterprise-value multiples are essential because they neutralise the differing debt, but EBITDA flatters and EV/EBIT is the honest read. For a stable consumer firm, P/E and free-cash-flow yield fit cleanly and the whole question collapses to whether growth justifies the premium. For an early-stage loss-maker there is no honest earnings multiple at all, and price-to-sales is a placeholder pricing a profitability that may never come. Same shelf of multiples, four different tools called for - and the discipline is the one this whole part has taught: know the business first, pick the multiple its economics actually fit, and read the expectation the multiple prices rather than calling the number cheap or dear on its own. The multiple is where the market's expectation is written down; the next part, on why prices move, reads what is written there.

A composite branded consumer company trades at a P/E of 55, and two readers look at the same number. One says "far too expensive - 55 times earnings is absurd" and passes. The other says "quality compounder, worth every rupee" and buys. Neither has actually read the multiple; both have reacted to its level. Read the expectation inside it instead. illustrative

A P/E of 55 is a statement about the future, so unpack what future it requires. Turn it around: to earn a reasonable return from here, the earnings have to grow fast enough, for long enough, to bring that multiple down to something ordinary over your holding period. Do the rough arithmetic. If the business can compound earnings at, say, 20% a year for a decade while holding its high return on capital and its cash conversion, then today's 55 is demanding but not absurd, because the earnings will have multiplied several times over. If the realistic growth is nearer 12%, then 55 is pricing in a decade of delivery the business is unlikely to manage, and the multiple is genuinely stretched. The number 55 did not answer the question; the growth-and-durability it requires did - and that is a judgement about the brand's moat, its runway, and its pricing power, not about whether 55 sounds high.

Then cross-check with a different lens. The free-cash-flow yield: at 55 times earnings even with high cash conversion, the FCF yield is only around 1.5–2%, which says plainly that you are being paid almost nothing in current cash and are buying entirely on future growth. And the PEG: 55 divided by 20% growth is close to 2.7, expensive even for a quality name. Put together, the multiple is neither "absurd" nor "worth every rupee" - it is a specific, demanding bet that this business compounds at a high rate for a long time, and whether to make it depends on your confidence in the runway, not on how 55 feels.

The enterprise-value multiples earn their keep the moment leverage enters. Two firms can sit on an identical 9× EV/EBITDA while one barely borrows and the other is heavily indebted - because enterprise value adds each firm's net debt to its market cap, and lands both at the same whole-firm price. A P/E would have split them apart on financing alone.

A valuation multiple cannot tell you whether the expectation inside it is correct - only what that expectation is. A P/E of 40 tells you the market is pricing strong growth; it cannot tell you whether that growth arrives. Deciding whether the expectation is too optimistic or too pessimistic is the work of building your own view of the business and setting it against the market's - a judgement the multiple frames but does not make. The number reveals the bet; whether the bet is good is a separate, harder question, and the whole subject of the part on why prices move.

Nor can a multiple see the quality of the earnings or assets it divides by. A P/E rests on earnings that may be flattered by aggressive accounting or one-offs; a price-to-book rests on a book value that may carry impaired assets or hidden liabilities; an EV/EBITDA rests on an EBITDA that ignores real depreciation and can be inflated. A multiple computed on a manipulated denominator is precise and worthless, and gives no warning that it is. Whether the earnings and assets underneath are honest is a question for the cash-quality checks and the forensics part, not for the ratio.

And multiples are only comparable within a genuinely comparable set. The same P/E means different things for a cyclical and a stable earner; the same price-to-book means different things for a bank earning 18% on equity and one earning 8%; the same EV/EBITDA means different things for a firm with light capex and one that must reinvest constantly just to stand still. Ripping a multiple out of its sector and its growth-and-return context to rank it against unlike companies - exactly what a screen does - produces a false ordering. The multiple supplies the market's expectation; it cannot supply the comparison that makes the expectation meaningful. That you must bring.

1. Reading a multiple as cheap or dear on its level. A multiple is a claim on the future; the same P/E is expensive on slow growth and cheap on fast growth. Read the growth and durability it prices, not the number alone.

2. Using P/E to compare differently-levered firms. Earnings are struck after interest, so a heavily-indebted firm's P/E reflects its financing. When leverage differs, the enterprise-value multiples are the fair comparison.

3. Trusting EBITDA multiples on asset-heavy businesses. EBITDA ignores depreciation, a real cost for a firm that consumes its assets. EV/EBIT, which charges depreciation, is often the truer read for capital-heavy operators.

4. Applying the wrong multiple to the sector. EV/EBITDA on a bank, P/E on a loss-maker, price-to-book on an asset-light firm - each is a category error. Match the multiple to the business.

5. Reading a cyclical's trailing P/E straight. At the peak a low P/E sits on record earnings and signals expensive; at the trough a high P/E sits on depressed earnings and can signal cheap. The multiple inverts against the cycle; anchor on book value or mid-cycle earnings.

6. Trusting a multiple without checking its denominator. A P/E on flattered earnings, a P/B on impaired assets, an EV/EBITDA on inflated EBITDA - each precise and worthless. Cross-check with free-cash-flow yield, built on harder-to-fake cash.