By the end of this lesson you know the three most-used valuation multiples -- P/E ratio, EV/EBITDA, and P/B -- what question each one answers, and why none is automatically better than the others.
\nThis level's Module 1 introduced comparable multiples as the second main family of valuation methods, alongside the DCF already developed in the previous module. This lesson develops the three multiples most used in practice.
\nThe P/E ratio compares a share's price with the net income attributable to it -- the company's net income, already covered in Level 2, divided across the number of shares. A P/E of 15 means, simplified, that the market is paying fifteen times the company's current annual net income to own it. It's the most-cited multiple, but it carries the same problem as net income: the effect of how the company is financed.
\nEV/EBITDA responds to that problem from another angle. It compares the company's Enterprise Value -- its full value, calculated by adding net financial debt to market capitalization, already covered in Level 1 -- with its EBITDA, a variant of operating income, already covered in Level 2, that adds back depreciation and amortization. By including debt in the numerator and using an earnings figure that doesn't subtract interest, EV/EBITDA neutralizes the effect of the financing structure -- the same spirit that led ROIC, already covered in Level 2, to look at total invested capital instead of equity alone.
\nP/B compares a share's price with the equity attributable to it, already covered in Level 2. It's especially informative for asset-intensive companies -- where what the company owns is a relevant reference -- or for financial institutions. In businesses with few tangible assets, like many service companies, it tends to say much less than the P/E ratio or EV/EBITDA.
\nNone of the three multiples is automatically the right one: each answers a different question, and the choice depends on the type of company and what you want to neutralize -- the financing structure, in the case of EV/EBITDA, or the weight of assets, in the case of P/B.
\nTwo companies in the same sector, one with much more debt than the other, can show a very different P/E and yet a similar EV/EBITDA -- precisely because EV/EBITDA neutralizes the effect of that financing difference that the P/E doesn't filter out.
\nThe P/E ratio compares price with net income per share, EV/EBITDA compares the company's full value with its EBITDA while neutralizing the financing structure, and P/B compares price with equity per share. Each answers a different question and is more or less informative depending on the company.
\nWhy can EV/EBITDA be more comparable between companies with different financing structures than the P/E ratio?
\nIn what type of companies is P/B usually more informative?
","sortOrder":1,"readingMinutes":9,"difficulty":"Intermedio"},"previous":null,"next":{"id":59,"moduleId":21,"slug":"how-are-comparable-companies-chosen","title":"How are comparable companies chosen?","summary":"You understand what makes a company a reasonable comparable for another, and why comparing against poorly chosen companies distorts the reading of any multiple.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand what makes a company a reasonable comparable for another, and why comparing against poorly chosen companies distorts the reading of any multiple.\n\n## Content\n\nA multiple says nothing on its own. A P/E of 15 isn't high or low until it's compared with that of other reasonably similar companies -- the comparables. Choosing that group well matters as much as choosing the right multiple, and it requires looking beyond shared sector.\n\nThe first filter is sector or industry: two companies in different sectors usually have such different margin, asset, and growth structures that their multiples aren't comparable to each other. But belonging to the same sector isn't enough: within the same sector, the business model can vary a lot -- one company might sell directly to consumers and another through distributors, for example -- and that difference also affects what multiple is reasonable.\n\nGrowth is another essential filter. A fast-growing company rightly tends to deserve a higher multiple than a mature, stagnant company in the same sector -- comparing their multiples without accounting for that growth difference leads to wrong conclusions.\n\nProfitability and business quality also need to be comparable: competitive advantage and consistency of results over time, already covered in Level 2, aren't the same across every company in a sector. A company with a real competitive advantage and consistent results normally deserves a higher multiple than one without those characteristics, even within the same sector and with similar growth.\n\nSize matters too -- companies of very different scales can trade at different multiples for reasons of liquidity or access to capital that have nothing to do with business quality. And, depending on the multiple used, financial structure can be relevant: comparing the P/E of companies with very different debt levels is more problematic than comparing their EV/EBITDA, which already neutralizes that effect.\n\nNo group of comparables is perfect on all these dimensions at once. An analyst's judgment consists of choosing the set of reasonably similar companies on the dimensions that matter most for the question being asked, not searching for an exact match that doesn't exist.\n\n## Example\n\nComparing the P/E ratio of a fast-growing tech company with that of a mature company in the same sector, without accounting for the growth difference, can make the first look \"expensive\" when in reality its higher multiple reflects different growth expectations, not necessarily overvaluation.\n\n## Common mistakes\n\n- Choosing comparables just for belonging to the same sector, without checking whether they have a similar business model, growth, or business quality.\n- Ignoring size or financial structure differences between the companies being compared, especially when using the P/E ratio.\n\n## Summary\n\nA reasonable comparable company resembles another in sector, business model, growth, profitability and business quality, size, and -- depending on the multiple -- financial structure. No comparable is perfect on every dimension; choosing the comparable group well matters as much as choosing the right multiple.\n\n## Self-check\n\nWhy might two companies in the same sector not be good comparables for each other?\n\nWhy does financial structure matter more for the P/E ratio than for EV/EBITDA?","bodyHtml":"By the end of this lesson you understand what makes a company a reasonable comparable for another, and why comparing against poorly chosen companies distorts the reading of any multiple.
\nA multiple says nothing on its own. A P/E of 15 isn't high or low until it's compared with that of other reasonably similar companies -- the comparables. Choosing that group well matters as much as choosing the right multiple, and it requires looking beyond shared sector.
\nThe first filter is sector or industry: two companies in different sectors usually have such different margin, asset, and growth structures that their multiples aren't comparable to each other. But belonging to the same sector isn't enough: within the same sector, the business model can vary a lot -- one company might sell directly to consumers and another through distributors, for example -- and that difference also affects what multiple is reasonable.
\nGrowth is another essential filter. A fast-growing company rightly tends to deserve a higher multiple than a mature, stagnant company in the same sector -- comparing their multiples without accounting for that growth difference leads to wrong conclusions.
\nProfitability and business quality also need to be comparable: competitive advantage and consistency of results over time, already covered in Level 2, aren't the same across every company in a sector. A company with a real competitive advantage and consistent results normally deserves a higher multiple than one without those characteristics, even within the same sector and with similar growth.
\nSize matters too -- companies of very different scales can trade at different multiples for reasons of liquidity or access to capital that have nothing to do with business quality. And, depending on the multiple used, financial structure can be relevant: comparing the P/E of companies with very different debt levels is more problematic than comparing their EV/EBITDA, which already neutralizes that effect.
\nNo group of comparables is perfect on all these dimensions at once. An analyst's judgment consists of choosing the set of reasonably similar companies on the dimensions that matter most for the question being asked, not searching for an exact match that doesn't exist.
\nComparing the P/E ratio of a fast-growing tech company with that of a mature company in the same sector, without accounting for the growth difference, can make the first look "expensive" when in reality its higher multiple reflects different growth expectations, not necessarily overvaluation.
\nA reasonable comparable company resembles another in sector, business model, growth, profitability and business quality, size, and -- depending on the multiple -- financial structure. No comparable is perfect on every dimension; choosing the comparable group well matters as much as choosing the right multiple.
\nWhy might two companies in the same sector not be good comparables for each other?
\nWhy does financial structure matter more for the P/E ratio than for EV/EBITDA?
","sortOrder":2,"readingMinutes":8,"difficulty":"Intermedio"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":70,"slug":"valuation-multiple","term":"Valuation multiple","shortDefinition":"A ratio that compares a company's price with one of its financial figures -- earnings, EBITDA, or book value -- to value it by comparison with other companies.","longDefinition":"A valuation multiple compares a company's price -- its market price or its full enterprise value -- with one of its own financial figures, to estimate its value by comparison with similar companies, instead of projecting its future cash flows the way a DCF does. It's the second main family of valuation methods. The three most-used multiples are the P/E ratio (price versus net income), EV/EBITDA (enterprise value versus EBITDA), and P/B (price versus equity), each more informative depending on the type of company and its financing structure. No multiple means anything on its own: it's only useful compared with that of reasonably similar companies."}},{"concept":{"id":71,"slug":"pe-ratio","term":"P/E ratio","shortDefinition":"A multiple that compares a share's price with the net income attributable to it -- how many years of current earnings the market is paying for the company.","longDefinition":"The P/E ratio (price-to-earnings ratio) compares a share's price with the net income attributable to it -- the company's net income, already covered in Level 2, divided across the number of shares. A P/E of 15 means, simplified, that the market is paying fifteen times the company's current annual net income to own it. It's the most widely used multiple, but it carries the same problem as net income: the effect of how the company is financed. Comparing the P/E of two companies with very different financing structures can lead to wrong conclusions."}},{"concept":{"id":72,"slug":"ev-ebitda","term":"EV/EBITDA","shortDefinition":"A multiple that compares a company's full value -- market cap plus net debt -- with its EBITDA, neutralizing the effect of its financing structure.","longDefinition":"EV/EBITDA compares a company's Enterprise Value -- its full value, calculated by adding net financial debt to market capitalization, already covered in Level 1 -- with its EBITDA, a variant of operating income, already covered in Level 2, that adds back depreciation and amortization. Unlike the P/E ratio, EV/EBITDA neutralizes the effect of how the company is financed -- the same spirit that led ROIC, already covered in Level 2, to look at total invested capital instead of equity alone -- which lets you compare companies with very different debt levels."}},{"concept":{"id":73,"slug":"pb-ratio","term":"Price-to-Book (P/B)","shortDefinition":"A multiple that compares a share's price with the equity attributable to it -- especially informative for asset-intensive or financial companies.","longDefinition":"Price-to-Book (P/B) compares a share's price with the equity attributable to it -- the company's equity, already covered in Level 2, divided across the number of shares. It's especially informative for asset-intensive companies -- where what the company owns is a relevant reference -- or for financial institutions, where earnings can be more volatile than equity. In businesses with few tangible assets, like many service companies, P/B tends to be much less informative than the P/E ratio or EV/EBITDA."}}]}