What it means
Knowing that a share costs $60 tells you very little by itself. A price multiple puts the price in context by dividing it by something that reflects value, such as profit per share, sales per share or the net assets per share.
The result is a single number that can be compared across companies, industries and time. The best known is the price-to-earnings ratio (P/E), which divides the share price by earnings per share.
A P/E of 15 means investors pay $15 for every $1 of annual profit. Other common multiples include price to sales (P/S), price to book (P/B) and price to cash flow.
Multiples are widely used for valuation by comparison. An analyst takes the average multiple of similar listed companies and applies it to the target company's earnings, sales or assets to estimate a fair price.
This is quick and grounded in market evidence, which is why it is common in takeover advice and in valuing private businesses. Different multiples suit different situations.
P/E works for steady profitable firms, P/S is helpful when profits are small or negative, and P/B is common for banks and other asset-heavy firms. Choosing a multiple that does not fit the business can mislead.
A high multiple is not necessarily bad, and a low multiple is not necessarily a bargain. A high P/E may reflect strong expected growth, while a low one may reflect doubts about the future.
Always compare with close peers, check how profit is defined, and ask what is driving the gap. Finally, remember that multiples are only as good as the figures behind them.
One-off gains, accounting choices and different year ends can distort comparisons. Adjusting for unusual items before calculating gives a cleaner picture.
In practice
Real-world examples.
Example
An investor compares two retailers. One trades at a P/E of 12 and the other at 20, though both have similar growth. She investigates why the market is paying more for the second one before choosing. She finds that its sales are growing faster, which partly explains the premium.
Example
A private equity firm values a small software business using price to sales. It takes an average multiple of 3 from listed peers and applies it to the target's revenue of $10,000,000. The indicative value is $30,000,000, which becomes the starting point for negotiations. The firm then adjusts the figure for the target's smaller size and weaker margins.
Example
A bank analyst values a regional lender on price to book. The bank has net assets of $500,000,000 and a market value of $450,000,000, so P/B is 0.9. She asks whether poor loan quality explains why it trades below its book value.
Formula
Calculation
P/E = share price / earnings per share; P/S = market value / revenue; implied price = peer multiple x company's own measure.
A company's share price is $60 and its earnings per share are $4, so P/E = $60 / $4 = 15. It has 10,000,000 shares, so its market value is $60 x 10,000,000 = $600,000,000. With revenue of $400,000,000, P/S = $600,000,000 / $400,000,000 = 1.5. If similar companies trade at an average P/E of 18, an implied price for this company is 18 x $4 = $72, which is $12 above the current price. The P/E of 15 and the implied value are rough guides, not precise answers, so the analyst would also test other multiples and adjust for differences in growth and risk. A range of values, for example $60 to $72, is a more honest result than a single price.Case study
Seen in the real world.
Oakhurst Foods is a fictional listed company used here for illustration. Its shares traded at a P/E of 10 while the average for similar food companies was 16.
An investor saw an opportunity and bought, assuming the gap would close. Digging deeper, a finance manager noted that Oakhurst's earnings included a one-off $5,000,000 gain from selling land, which had inflated profit and made the P/E look low.
Once the gain was removed, the illustrative P/E rose to 14, much closer to the peer average. The case shows why multiples need adjusted earnings to give a fair comparison. The investor revised the analysis, held back from buying and waited for stronger operating results.
Watch out
Common mistakes.
- Treating a low multiple as proof of a bargain. It may reflect weak growth, high risk or poor quality profit.
- Comparing companies in different industries. Normal multiples differ widely between sectors.
- Using unadjusted earnings. One-off gains and losses distort the ratio.
Questions
People also ask.
What is a good P/E ratio?
There is no universal answer, because it depends on growth, risk, interest rates and industry, so compare with peers and history.
Which multiple should I use for a loss-making company?
Price to sales or another revenue-based multiple is often used because earnings are negative.
What is the difference between trailing and forward multiples?
Trailing multiples use past results, while forward multiples use forecast figures. Forward multiples depend on how reliable the forecasts are.
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