Multiples are the fastest way to compare what you pay for different businesses. They are also the most misused number in investing, because a multiple compresses an entire future into one ratio. Knowing what each one hides is as important as knowing how to calculate it.
A multiple divides what you pay by something the company produces: earnings, sales, cash flow. A lower multiple means you pay less for each unit, but only if that unit is as good and will grow as fast. Multiples must always be compared with something: the company's own history, its peers, and its growth.
What to look at
- P/E = Share price ÷ EPS. Forward P/E uses next year's expected EPS; trailing uses the last twelve months.
- EV/EBITDA uses enterprise value (market cap + net debt), so it compares companies with different debt levels fairly.
- P/S (price to sales) is used for companies that are not yet profitable. It ignores margins entirely.
- PEG = P/E ÷ expected growth rate. It adjusts for growth but depends heavily on the growth estimate.
- FCF yield = Free cash flow ÷ Market cap. It is the inverse of a cash-based multiple and is easy to compare with bond yields.
The shape of it
Enterprise value = Market cap + Debt − Cash
An example
Two companies trade at 15× earnings. One has net cash and grows 12% a year; the other has heavy debt and flat sales. They are not equally cheap: on EV/EBITDA, the indebted company is far more expensive.
Where people go wrong
A very low P/E often means the market expects earnings to fall, as at the peak of a cycle or before a disruption. Ask why it is cheap before concluding that it is.
Use multiples to frame questions, not to answer them. If a stock looks cheap, your job is to find the reason the market disagrees and decide whether the market is right.