Relative Valuation and Multiples
Relative Valuation and Multiples tests whether a stock is cheap or expensive versus peers, transactions, or its own history. The exam focuses on multiple selection, numerator-denominator consistency, and adjustments.
Core rules
- P/E is price per share divided by EPS. Use forward EPS for forward P/E; trailing EPS for trailing P/E. A high P/E can reflect high expected growth, low risk, or mispricing.
- EV/EBITDA compares enterprise value with pre-interest, pre-tax operating earnings. EV = market capitalization + debt + preferred + minority interest − cash.
- P/B is useful for financial firms and asset-heavy businesses; P/S can be used when earnings are negative but says nothing about cost control.
- Multiples must be applied to a comparable metric. Apply EV/EBITDA to EBITDA and derive equity value by subtracting net debt.
- Adjust for non-recurring items, accounting differences, calendarization, and control premiums when using transaction multiples.
Worked example
A target has EBITDA of $50 million, net debt of $120 million, and 20 million shares. The peer median EV/EBITDA is 8.0×. Enterprise value is 8.0 × $50 = $400 million. Equity value is $400 − $120 = $280 million. Value per share is $280 ÷ 20 = $14.00. At a market price of $12.00, the shares look undervalued by $2.00, or 16.7%, before considering control or liquidity adjustments.
Traps
Do not compare a P/E with an EV/EBITDA. Do not use EV as equity value. A negative P/E is not “cheap”; it is usually meaningless. Peer medians can hide accounting and business-mix differences. Cyclical companies can look cheapest at peak earnings, just before a downturn.