The Deceptive Simplicity of Relative Valuation

The price to earnings (P/E) ratio is among the more popular tools your typical analyst or retail enthusiast might use. It provides a quick heat check; is the stock cheap and (perhaps) growing slowly or expensive and yet rapidly expanding? A quick look to multiples across the firm’s industry peers grants you a relative viewpoint. Flipping the division results in an intuitive understanding of yield. And best of all, it avoids all the ‘unnecessary assuming’ one has to do in those intractable discounted cash flow (DCF) models. But is that accurate?

It would seem that all that is required in a multiple based valuation is the growth of the underlying profitability metric (e.g. earnings per share (EPS)) coupled with an ‘appropriate’ exit multiple. Just what determines the appropriateness of this number is an elusive question. This article looks to uncover why the simplicity of multiples are largely illusory.

A Valuation Tautology

It matters little whether the multiple used was based off of the firm average or industry median (the latter being a relative valuation). What should be alarming is the extent to which small differences in the exit multiple dramatically change “value”. Assuming a cost basis of 72$ per share, price appreciation can range anywhere from 11% to 28%. Though we are making only one assumption, it is a rather large and consequential one.

It can be argued that labelling a slipshod combination of an EPS growth rate and a desired exit multiple as a ‘valuation’ is tenuous to begin with. Let us uncover the not so hidden tautology:

We can secure an earnings estimate from analyst consensus or extrapolate further from past performance. Knowing this number, we can naturally multiply by the number of shares outstanding to arrive at the denominator of our next figure. All that remains is to determine the price (i.e. the appropriate multiple). But this was the very point of the exercise to begin with. The multiple already reflects the market’s estimate of value. Incorporating that into our valuation formula leaves us with nothing but a redundancy.

The Trouble with Earnings Per Share

Intangible Investments

Exit multiple troubles aside, reliance on earnings and earnings growth as a measure for value accretion has become more and more precarious in recent decades.

SOURCE: WIPO–LBS Global INTAN-Invest Database, July 2025

The share of investment attributable to intangible assets has risen manifold relative to physical assets, and especially so in developed countries. US GAAP rules (as opposed to IFRS) prohibit the capitalization of such investments altogether, and so it happens to be that the country leading in intangible investments sees the earnings of its corporations most deflated. The timing mismatch is such that the cost of investment does not correspond with when those revenues would be expected to contribute to the bottom line. Rather, near-term earnings are depreciated and future earnings outperform, as is demonstrated in the example below. An intangible investment of 20$ is fully expensed against revenue for within the year. EPS is understated significantly and by extension, growth in the following period is exaggerated. When the investment finally has a say at the top line (20X6), the increase in margins is disguised as operating leverage.

The Disfiguring Effect of Intangibles

This is one reason why firms such as Meta and Microsoft have been consistently topping analyst estimates as of late. AI, cloud infrastructure, and other such R&D costs have already been expensed against past income whereas the bulk of the revenue is being generated today.

When Growth is Undesirable

An analyst relying on earnings growth but over a long enough timeframe may escape the above consequences, though a critical shortcoming remains; projected growth in earnings does not consider the cost of growth.

Growth at the Cost of Value

Consider the above scenario of a firm in a mature industry earning 56$ after tax (20X1) with zero future prospects for growth. Assuming no debt and a cost of equity of 7%, we can value this perpetuity at 80$ per share (EPS / Cost of Equity). The next year, our resourceful CEO chalks up a plan for a 5$ investment boosting sales by 10$ for the foreseeable future. This sounds like good news at when taken at face value. However, given our cost of equity, the incremental growth in post-tax profits of 2.8$ is not enough to justify the present value of investment. The firm has destroyed value.

Where Do Multiples Belong?

None of the above is to claim that there is no time and place for the use of multiples. So long as it is recognized that a market or industry multiple already conceals a valuation, relative methods still serve a purpose. If, by way of a DCF model, the P/E ratio implied by your valuation is 3 times the industry median, there is either something exceptionally special about your firm or exceptionally flawed about your methods.