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Lesson 1 of 10 · 14 min

Price multiples and the method of comparables

A price multiple compares a share's price with a per-share fundamental; you can judge it against fundamentals (the justified P/E from the Gordon model) or against similar companies (the method of comparables).

Video lesson · 6 min. Watch it first, then use the text below to go deeper.

In short

Main multiples: P/E, P/B, P/S and P/CF (cash flow = operating or free cash flow).
Trailing multiples use past values; forward (leading) multiples use forecasts. Use the same basis for every company compared.
Justified forward P/E from the Gordon model: $P_0/E_1 = p/(r-g)$ , where p = payout ratio.
P/E rises with g, falls with r. A higher payout need not raise P/E, because it can lower growth (dividend displacement of earnings).
Method of comparables rests on the law of one price: benchmark a multiple against a close peer, the industry average or median, or the company's own history.

The main price multiples

A price multiple is the share price divided by a monetary measure per share. It lets you judge the relative worth of a share quickly. Some practitioners use multiples to screen: buy candidates below a threshold, sell candidates above one. Others treat the stocks with the lowest multiples in a sector as the most attractive.

P/E (price to earnings per share) is the most widely quoted multiple, and research has linked low P/E stocks to higher returns. P/B (price to book value per share) has been found to be inversely related to future returns. P/S (price to sales per share) has been argued to be a strong predictor too. P/CF divides the price by a per-share cash flow, either operating cash flow or free cash flow.

A common criticism is that multiples ignore the future. That is true only if the divisor is a trailing figure. Forward (leading, prospective) multiples use forecasts of next year's fundamentals, and can differ a lot from trailing multiples. Even a trailing multiple carries an implicit forecast. Whichever you choose, apply it consistently across the companies being compared.

Industries also have their own measures, such as market value per subscriber for cable companies or proved reserves per share in oil. They highlight the key business drivers and can flag attractively valued shares.

Rhône Équipement: price EUR 64.00
Multiple	Per-share fundamental	Multiple
Trailing P/E	Last year's EPS 3.20	20.0
Forward P/E	Next year's EPS forecast 4.00	16.0
P/B	Book value 25.60	2.5
P/S	Sales 40.00	1.6
P/CF	Operating cash flow 5.12	12.5

Linking P/E to fundamentals: the justified P/E

Multiples can be tied to a present value model. Assume the price equals the Gordon value, $P_0 = D_1/(r-g)$ , and divide both sides by next year's earnings $E_1$ . The result is the justified forward P/E: $P_0/E_1 = (D_1/E_1)/(r-g) = p/(r-g)$ , where p is the dividend payout ratio.

It is 'justified' because it is the multiple the fundamentals support. It is simply another way of expressing an intrinsic value estimate, and it can explain why companies have different multiples without any mispricing.

The formula shows that P/E is inversely related to the required return and positively related to growth. It looks positively related to the payout ratio too, but that can mislead: paying out more means retaining less, which can lower g. This is the dividend displacement of earnings. With ROE of 10% and r = 9%, raising the payout from 60% to 70% cuts g from 4% to 3%, and the justified P/E falls from 12.0 to 11.7.

With the payout fixed at 60%, raising expected growth from 4% to 6% lifts the justified P/E from 12 to 20. Justified multiples are as sensitive to r − g as the Gordon model itself.

The method of comparables

The method of comparables is the most widely used way to report valuations based on multiples. It needs no cash flow forecasts or discounting. Its economic logic is the law of one price: identical assets should sell for the same price.

Compare the share's multiple with a benchmark: the multiple of a closely matched company, the average or median of its industry, or the company's own past multiples (a time-series or trend analysis). A multiple below the benchmark suggests undervaluation, above it overvaluation.

Choosing comparables is the hard part. Large companies often run several businesses, so look for peers that match on size, product lines and growth. The fundamentals in the justified P/E (r, g, payout) show which differences can legitimately explain a different multiple.

P/E can mislead for cyclical companies, because earnings swing with the business cycle under operating and financial leverage. Sales move less in percentage terms, so P/S is a useful alternative in a slowdown or a boom.

The five peers have a median forward P/E of 16.4. Brenne trades at 13.3, below every peer, so it looks relatively cheap, unless lower growth or higher risk explains the discount.

Strengths and cautions

The main advantage of multiples is that they allow relative comparisons, both across companies and over time. That suits analysts covering one industry who must pick the best performers within it. Multiples are also easy to calculate and widely published.

There are cautions. A share can be cheap relative to its peers but still overvalued against its intrinsic value from a discounted cash flow model, for example if the whole sector is expensive. Differences in accounting standards and methods can make earnings, book values and cash flows hard to compare. And multiples of cyclical companies are heavily influenced by current economic conditions.

Multiples also fail when the divisor is negative or tiny: a company with losses has no meaningful P/E. Then other multiples such as P/S or P/CF, often industry-specific ones, help.

Formulas

Price multiples: $\dfrac{P}{E},\ \dfrac{P}{B},\ \dfrac{P}{S},\ \dfrac{P}{CF} = \dfrac{\text{Price per share}}{\text{Fundamental per share}}$
Trailing: last year's fundamental. Forward: next year's forecast.
Justified forward P/E: $\dfrac{P_0}{E_1} = \dfrac{D_1/E_1}{r-g} = \dfrac{p}{r-g}$
p = dividend payout ratio; requires r > g. Divide the Gordon model by next year's EPS.
Value from a multiple: $V_0 = \text{Benchmark multiple} \times \text{Fundamental per share}$
E.g., justified or peer P/E × forecast EPS.

Worked examples

Example 1 Trailing and forward multiples

Rhône Équipement trades at EUR 64.00. Last year's EPS was 3.20 and next year's is forecast at 4.00. Book value per share is 25.60, sales per share 40.00 and operating cash flow per share 5.12. Compute the multiples.

Example 2 Justified forward P/E

Cerro Alimentos pays out 60% of earnings, earns an ROE of 10% and has a required return of 9%. Next year's EPS is forecast at 3.50 and the shares trade at 38.00. Find the justified forward P/E, the implied value and a conclusion.

Example 3 Method of comparables

Five comparable food producers have forward P/Es of 14.2, 15.8, 16.4, 17.1 and 19.5. Brenne Foods has forward EPS of 2.85 and trades at 38.00. Use the peer median to value Brenne and interpret the result.

On the exam

Expect P/E calculations (trailing versus forward), a justified forward P/E from payout, r and g, the direction of P/E against r, g and payout, and picking the cheapest of several similar companies on two multiples.

Using the retention rate instead of the payout ratio in the numerator of $p/(r-g)$ .
Saying P/E rises with the required return: it falls.
Assuming a higher payout always raises P/E, ignoring dividend displacement of earnings.
Mixing trailing and forward multiples across companies.
Concluding a stock is undervalued in absolute terms just because it is cheap relative to peers.

Check yourself

Q1A company pays out 40% of earnings, its dividends are expected to grow 6% a year forever and its required return is 10%. Its justified forward P/E is closest to:
Q2A justified P/E derived from the Gordon growth model is inversely related to the:
Q3A share trades at 48.00. Last year's EPS was 3.20 and next year's EPS is forecast at 4.00. Its forward P/E is closest to:
Q4Three similar banks have the following multiples. Alder: P/B 1.30, P/E 9.6. Birch: P/B 0.80, P/E 12.4. Cedar: P/B 0.80, P/E 9.1. Which is most likely undervalued?
Q5An analyst says: 'A higher payout ratio always gives a higher justified P/E.' The statement is most likely:
Q6The economic rationale for the method of comparables is most accurately described as:

0/6Check yourself

Answer the 6 questions: +10 XP for each one you get right first time.

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