P/E and friends: quick ways to compare prices
A full value estimate takes work. A valuation multiple is the shortcut: price divided by something the business produces or owns. Here are the common ones, a comparison of two made-up pizza companies, and the ways each shortcut can mislead.
Why divide the price by something?
A $50 share is not automatically pricier than a $10 share; it may have far more profit behind it. To compare fairly, you divide the price by some measure of the business, like profit or sales. The result is a multiple: how many dollars you pay for each dollar of that measure.
A multiple is a compressed version of the cash-flow math in the intrinsic value lesson. A high multiple quietly assumes strong growth or low risk. A low one assumes the opposite.
Two ways to measure the price: market cap and enterprise value
Market cap (market capitalization) is the share price times the number of shares: the price of the owners’ slice.
Lenders have a claim too. Enterprise value (EV) is the price of the whole business: market cap, plus debt, minus the company’s cash.
Think of buying a food truck. The seller wants $40,000. The truck still has a $20,000 loan that you must take over. There is $5,000 in the cash box, and it comes with the truck. Your real cost is $40,000 + $20,000 − $5,000 = $55,000. The $40,000 is like market cap. The $55,000 is like enterprise value.
The common multiples
- P/E (price to earnings): share price ÷ earnings per share, or market cap ÷ net income. A P/E of 10 means you pay $10 for each $1 of yearly profit. Net income is the bottom-line profit (see the income statement lesson).
- P/B (price to book): market cap ÷ book value. Book value is what the balance sheet says the owners’ stake is worth: assets minus debts and other obligations.
- P/S (price to sales): market cap ÷ yearly revenue. Useful when there is no profit to measure.
- EV/EBITDA: enterprise value ÷ EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. In plain words, it is operating profit before the charges for wear and tear on equipment (depreciation) and on things like patents (amortization). Because EV includes debt and EBITDA comes before interest, this pair ignores how a company is financed.
- Free cash flow yield: free cash flow ÷ market cap, as a percentage. Free cash flow is the cash left after the bills and needed equipment purchases. A higher yield means more cash per dollar of price.
For the first four, lower means cheaper. For free cash flow yield, higher means cheaper.
Oak Street Pizza Inc. and Riverbend Pizza Inc. are made-up companies of the same size. Each has 1 million shares, $25 million of yearly sales, $4 million of EBITDA and $1 million of cash. Each also has $1 million of depreciation, pays a 25% tax rate, and spends $1.2 million a year on new equipment. The big difference is debt: Oak Street owes $3 million, Riverbend owes $15 million.
Step 1: profit after interest. Both start with $4 million − $1 million depreciation = $3 million of operating profit.
- Oak Street pays $0.2 million interest: $3.0 − $0.2 = $2.8 million before tax. Tax: $2.8 × 0.25 = $0.7 million. Net income: $2.1 million.
- Riverbend pays $1.0 million interest: $3.0 − $1.0 = $2.0 million before tax. Tax: $0.5 million. Net income: $1.5 million.
Step 2: free cash flow. Net income + depreciation (a charge that used no cash this year) − equipment spending. Oak Street: $2.1 + $1.0 − $1.2 = $1.9 million. Riverbend: $1.5 + $1.0 − $1.2 = $1.3 million.
Step 3: the multiples. Oak Street’s shares cost $21. Riverbend’s cost $12.
| Item | Oak Street | Riverbend |
|---|---|---|
| Market cap ($21 or $12 × 1 million shares) | $21.0M | $12.0M |
| Plus debt | $3.0M | $15.0M |
| Minus cash | $1.0M | $1.0M |
| Enterprise value | $23.0M | $26.0M |
| P/E ($21.0 ÷ $2.1; $12.0 ÷ $1.5) | 10.0 | 8.0 |
| P/S ($21 ÷ $25; $12 ÷ $25) | 0.84 | 0.48 |
| P/B (book value $10.5M and $6.0M) | 2.0 | 2.0 |
| EV/EBITDA ($23 ÷ $4; $26 ÷ $4) | 5.75 | 6.5 |
| Free cash flow yield ($1.9 ÷ $21; $1.3 ÷ $12) | 9.0% | 10.8% |
Step 4: read it. On P/E, P/S and free cash flow yield, Riverbend looks cheaper. On EV/EBITDA, Oak Street does. Why? The owner-only measures ignore Riverbend’s $15 million of debt. Anyone taking over the whole business inherits that debt, so the full price of Riverbend’s $4 million of EBITDA is $26 million, not $12 million.
Neither view is wrong; they answer different questions. But Riverbend’s debt is a real risk: in a bad year, the $1 million of interest is still due. A low P/E that comes from heavy borrowing is not the same as a low P/E at a debt-free business.
When each multiple helps, and when it misleads
Earnings that swing with the economy
Some businesses, like trailer makers, earn a lot in good years and little in bad ones. Their P/E looks lowest at the peak, just before profit falls.
Say Summit Trailers Inc. (made up) earns $5 a share in a boom year and trades at $40: a P/E of 8. If its earnings over a full up-and-down cycle average about $3, the price is $40 ÷ $3 = about 13 times normal earnings. For these businesses, use average earnings over several years.
Negative earnings
If a company lost money, P/E has no sensible meaning. People often switch to P/S, which is fine as a rough guide, but a company can sell a lot and still never turn a profit.
Banks versus software
For a bank, borrowed money is the raw material, so EV and EBITDA mean little. A bank holds mostly loans and investments, carried on the balance sheet at amounts fairly close to their worth, so P/B and P/E tell you more.
A software company is the opposite. Its most valuable things, its code, its customers and its people, mostly don’t appear on the balance sheet. Book value is tiny, so P/B looks huge and says little; cash flow measures help more.
One-time items
If a company sold a building this year, the gain lands in net income and makes the P/E look low, but it won’t repeat. Check for unusual lines before trusting one year’s P/E.
Using multiples well
Compare companies in the same industry, since a P/E of 15 means different things for a grocery chain and a chip designer. Compare a company with its own past. And look at more than one multiple: when they disagree, as in the pizza example, the disagreement is the clue.
- Multiple
- A price divided by some measure of the business, such as profit or sales.
- Market cap
- Share price × number of shares: the price of the owners’ stake.
- Enterprise value (EV)
- Market cap plus debt minus cash: the price of the whole business.
- P/E
- Price ÷ earnings; dollars paid per dollar of yearly profit.
- Book value
- Assets minus debts and other obligations, as shown on the balance sheet.
- EBITDA
- Operating profit before interest, taxes, depreciation and amortization.
- Free cash flow yield
- Free cash flow ÷ market cap; higher means more cash per dollar of price.
Where to see it on Filing.fyi
The header of each company page shows the market cap and a trailing P/E (based on the past year’s earnings). For the other multiples, open the latest 10-K from the filing timeline: revenue and net income are on the income statement, debt, cash and book value on the balance sheet, and free cash flow comes from the cash flow statement. The financial ratios lesson covers related measures.
Glance at the score cards too. A high Beneish M-Score means the earnings behind a P/E may be inflated, and a low Altman Z-Score says the debt deserves a closer look. The methodology page explains each score.
- A multiple is price divided by something the business earns or owns.
- Market cap prices the owners’ stake; enterprise value adds debt and subtracts cash.
- A low P/E can come from heavy debt, a peak year or a one-time gain.
- Pick the multiple that fits the industry: P/B for banks, cash flow for software.
- When multiples disagree, find out why. That is where the story is.
This lesson is education, not investment advice. Examples use made-up companies and round numbers unless a real filing is named.