Company A is a slow-growing retailer with 5% annual earnings growth. Company B is a high-growth tech firm with 35% annual earnings growth. Both earn $2 per share. Company A trades at P/E = 12 and Company B at P/E = 45. A junior analyst says Company B is overvalued relative to Company A because its P/E is nearly 4× higher. What is wrong with this reasoning?
ANothing — a higher P/E always indicates overvaluation relative to a lower P/E
BThe analyst should compare EV/EBITDA instead of P/E since both companies are in different industries
CP/E ratios are only comparable between companies with similar growth rates, risk, and capital structure; Company B's higher P/E may be justified by its much faster earnings growth
DThe analyst is correct only if both companies have the same dividend payout ratio
Investors pay a premium P/E for companies expected to grow earnings faster, because a dollar of earnings today from a high-growth firm represents far more future earnings than a dollar from a stable firm. Comparing P/E across companies with 5% vs 35% growth without adjustment is apples-to-oranges. The PEG ratio attempts to normalize for this — Company A has PEG = 12/5 = 2.4, Company B has PEG = 45/35 ≈ 1.3, suggesting Company B is actually cheaper on a growth-adjusted basis. Comparability of peers is the foundational assumption of multiples-based valuation.
Question 2 Multiple Choice
Why do analysts prefer EV/EBITDA over P/E when comparing a highly leveraged company to a nearly debt-free competitor in the same industry?
ABecause EBITDA is always larger than earnings, making the ratio easier to calculate
BBecause EV includes debt and EBITDA is pre-interest, so the ratio is capital-structure-neutral; P/E is distorted by how the company is financed
CBecause EV/EBITDA is calculated from market data while P/E requires accounting earnings, which can be manipulated
DBecause P/E only works for companies that pay dividends, while EV/EBITDA works for all companies
P/E compares equity market cap to net earnings (post-interest). A highly leveraged firm pays more interest, reducing net earnings and inflating P/E — making it look expensive even if its underlying business is equally productive. EV (enterprise value = market cap + net debt) captures the value of the whole business to all capital providers. EBITDA is pre-interest, so it represents operating cash flow before financing decisions. Together, EV/EBITDA lets you compare how the market values underlying business operations independent of financing choices — essential when capital structures differ.
Question 3 True / False
If every company in a sector has its P/E ratio inflated by speculative enthusiasm, using comps-based valuation will still show a target company as 'fairly valued' relative to its peers, even though it may be expensive in absolute terms.
TTrue
FFalse
Answer: True
This is the fundamental limitation of relative valuation: multiples tell you how a company looks *compared to* similar firms right now, not whether any of those firms are cheap or expensive in an absolute sense. During the dot-com bubble, tech companies with enormous P/E ratios could be 'fairly valued' by comps analysis — because all their comps were equally overvalued. The relative signal was neutral even while DCF analysis would have shown large overvaluation. This is why skilled analysts use multiples alongside intrinsic-value methods, not instead of them.
Question 4 True / False
A PEG ratio below 1 is a reliable signal that a stock is undervalued, since it indicates the market is pricing the stock below what its growth rate justifies.
TTrue
FFalse
Answer: False
PEG is a rule-of-thumb heuristic, not a rigorous valuation measure. It assumes a linear relationship between P/E and growth rate that doesn't hold in theory or empirical data. Companies with very high growth rates often deserve P/E multiples more than proportional to their growth (non-linearity of value), while very low-quality growth may deserve less. PEG also ignores risk, dividend yield, and the sustainability of forecast growth. A PEG below 1 is interesting evidence but not a reliable trigger — the growth rate itself must be validated, and quality and risk must be considered.
Question 5 Short Answer
Why do experienced analysts use both multiples-based valuation and DCF analysis rather than relying on one method alone? What does each method tell you that the other doesn't?
Think about your answer, then reveal below.
Model answer: Multiples (relative valuation) show how the market currently prices similar companies — they are fast, grounded in observable market prices, and capture current investor sentiment. DCF (intrinsic value) projects future cash flows and discounts them to present value, giving an independent estimate of what the business is worth regardless of what the market thinks now. When the two methods agree, confidence in the valuation is higher. When they diverge significantly, it is a signal to reexamine assumptions — either the DCF inputs are off, or the market (and therefore the comps) is mispricing the sector.
Multiples alone can validate irrational market pricing. DCF alone can be wrong if its assumptions are flawed. Together they triangulate: a company that looks cheap by both measures is a stronger buy case than one that is cheap by only one. This is the practitioner insight the topic builds toward.