The Most Misunderstood Metric In Finance - The P/E Multiple
Most investors misuse the P/E ratio. Here’s what the multiple actually means, why it’s often misunderstood, and how to use it correctly in valuation.
Most investors talk about the P/E multiple like it’s a universal truth handed down on stone tablets. CNBC flashes it like gospel, their own explainer on the metric treats P/E as a kind of default valuation shortcut. Analysts hide behind it. Retail investors cling to it like they’ve discovered a cheat code.
But here’s the uncomfortable truth: most people have no idea what a P/E multiple actually means. They use it like a buy/sell switch… when really, it’s just a snapshot of the market’s mood at a single point in time.
Used properly, the P/E multiple is a useful shorthand. Used recklessly, it’s financial napalm.
And if you’ve ever watched someone slap a 12x or 18x multiple on a company’s earnings and call it “valuation,” congratulations, you’ve witnessed someone splitting atoms in their imagination. (No shade to Ackman’s latest Fannie/Freddie thesis… but also, some shade.)
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What the P/E Ratio Actually Is
Literally, it’s: Market Price ÷ Earnings Per Share
Simple. Clean. Misleading.
The P/E tells you how much investors are willing to pay for every dollar of current earnings. You can also think of it as the number of years it would take to earn back your investment—if earnings stayed flat forever, if nothing changed, if the world froze in time.
Which, of course, it never does.
Here’s the big point people keep missing:
P/E is not a measure of value. It is a measure of price. It tells you nothing about intrinsic worth. Only what the market thinks is worth today.
Two stocks can both trade at 10x earnings, and one is a compounder, and the other is a slow-motion train wreck.
Two stocks can both trade at 40x earnings, and one is a bubble, and the other is early Amazon.
The P/E ratio is a vibe, dressed up as a number. It’s the market’s collective opinion… not the truth.
When humans, emotional, inconsistent, narrative-driven humans, are setting the price, the P/E ratio becomes less “mathematical precision” and more “a barometer of hope, fear, and delusion.”
Sorry Neo. Didn’t mean to go full Oracle on you. But someone had to say it.
What P/E Tells You (and What It Absolutely Doesn’t)
This is where we bring in the wizard himself.
Michael Mauboussin — Yoda of Valuation
Mauboussin is the quiet deity of this entire field. The guy hedge fund PMs actually listen to. The moment he drops a new paper, valuation nerds sprint to their terminals like toddlers to an iPad.
His key insight?
The P/E ratio isn’t one number. It’s two numbers stacked on top of each other.
The steady-state value (current earnings power)
The future value creation (growth expectations)
People blow themselves up when they ignore that second piece.
Let’s look at two examples:
Example A: The High-P/E Darling
P/E = 40
EPS = $1
Share price = $40
Looks expensive, right?
But if the company doubles earnings in five years (not crazy for great businesses)…
EPS goes from $1 → $4.
Now your “expensive” 40x stock is trading at: 10x earnings (without the share price moving at all).
Not expensive, just misinterpreted.
Example B: The Low-P/E “Value Trap”
P/E = 10
EPS = $1
Share price = $10
Looks cheap… until earnings fall to $0.50. Now your P/E ratio explodes to 20x even though the stock price is collapsing.
This is the Credit Suisse special. The same dynamic I broke down in $550 Billion in Losses, No Bailouts, where collapsing earnings turned “cheap” banks into landmines.
Cheap isn’t always cheap.
Low multiple ≠ value.
Low multiple can mean “run.”
Most people don’t understand this.
Bank investors definitely don’t.** and I wrote about why in How to Value a Bank, where low multiples often signal deteriorating returns, not opportunity.
They’ve been buying trash at 5x earnings for a decade while earnings quietly bleed out quarter after quarter. That “discount” wasn’t a discount—it was the market screaming “danger.”
Don’t be that guy. (Hint: I’ve been that guy.)
The Role of Growth and Cost of Capital (Hint: It’s Everything)
If Mauboussin is valuation Yoda, then Aswath Damodaran is Gandalf, the benevolent wizard who appears exactly when the finance world needs a reality check.
Professor at NYU Stern. Human valuation database. Patron saint of discounted cash flows. And the mortal enemy of bad financial takes.
When Damodaran drops a new paper, CFA candidates stop mid-exam, portfolio managers cancel meetings, and valuation nerds sprint to their computers yelling:
“WAKE UP—A NEW DAMODARAN POST JUST DROPPED.”
Here’s his big insight on P/E:
P/E is Driven by Two Forces:
1. Growth Rate
Companies with faster revenue and earnings growth deserve higher P/Es. That’s not speculation, it’s math.
If a company reinvests earnings at high returns, the magic of compounding kicks in. That makes every future dollar of earnings worth more today, which justifies a higher multiple.
This is why Amazon, Nvidia, and Tesla trade at premiums when they’re scaling quickly, and why those premiums naturally shrink as growth matures.
2. Cost of Capital
This part most investors ignore.
If future earnings are discounted at a low cost of capital, those earnings are more valuable → P/E goes up. If discounted at a high cost of capital (distress, leverage, sector risk), those future earnings lose value → P/E goes down.
Let’s break this down clearly:
Risk-free rate (10-year U.S. Treasury ~4.3%, per the Federal Reserve’s H.15 Treasury yield release)
Equity risk premium (5–6%)
Beta (1.0–1.2 for most stocks)
This gives a typical cost of equity around 9–11%.
And when you blend that with cheaper debt capital, you get WACC, the real weighted cost of funding.
High ROTCE/ROE vs. WACC
→ value creator
→ premium multiple justified
Low ROTCE/ROE vs. WACC
→ value destroyer
→ low P/E deserved
This is why banks with real discipline trade at 1.5–2.0x book, while sloppy banks trade at 0.6x forever.
Earnings Yield ≠ Cost of Capital (But It Helps)
Some investors take the inverse of P/E (E/P), call it “earnings yield,” and treat it as a proxy for cost of capital.
Not perfect—but not useless either.
AAPL earnings yield ≈ 2.8%
JPM earnings yield ≈ 8%
KRE (regional banks) ≈ 8–9%
If a company consistently earns above that implied hurdle, you get value creation. If not, you get a melting ice cube.
But again, this is shorthand—not gospel. Damodaran would slap you if you used E/P as the actual cost of equity.
Amazon vs. General Motors: The P/E Illusion
Let’s put all this into numbers.
Amazon (Early 2000s)
Traded at: 100x earnings
Earnings: tiny
Growth: ridiculous
People thought it was insane.
But earnings doubled. Then doubled again. Revenue compounding at 20–30% annually. Amazon reinvested every penny at absurd incremental returns.
A business like that should trade at 100x.
If a stock goes from 100x today to 25x in five years with no movement in price, you didn’t overpay—you bought early.
General Motors
P/E = 5x. Looks cheap… until earnings fall.
$5 EPS → $25 stock = 5x
$4 EPS → same $25 stock = 6.25x
$3 EPS → same $25 stock = 8.3x
The stock price eventually collapses to chase the shrinking earnings.
This is the danger:
Low P/E can be a value trap, and high P/E can be a bargain.
It all depends on the earnings trajectory.
Why High-Growth Companies Start With High P/Es (And Why They Fall Later)
Growth stocks almost always start with high multiples. Not because they’re expensive, but because they’re reinvesting everything.
Margins are low. Earnings look small. Cash flows look weak.
But growth is enormous.
Then two things happen:
Growth slows naturally
The P/E multiple compresses
This is not bearish. It’s simply the life cycle of a business.
Damodaran & Mauboussin both show that high-growth companies eventually see their multiples drop 30–50% even if fundamentals remain strong.
Finance has gravity. Multiple compression is gravity. Only Nvidia seems immune (for now).
Case Studies: When P/E Compression Happens to the Best
Microsoft (Late 90s → 2000s)
P/E: 50x
Dominant PC software
Incredible margins
Then the growth matured. P/E compressed to the low 20s.
Did Microsoft fall apart? No. The valuation simply matured.
Amazon (2000s → 2020s)
Amazon went from 100x → 30–50x even as revenue grew from $20B → $500B.
The business became stronger. The multiple became smaller. That’s normal.
Tesla (2020 → Now)
1500x earnings → sub-70x.
Not because Tesla imploded. Because growth slowed.
Apple (2010 → Today)
The rare exception: P/E expansion
10–15x → 30x
Because services revenue lifted margins and stability.
Growth changed → narrative changed → multiple changed.
Why This Matters for You
Understanding the life cycle of P/E multiples helps you avoid the two great ways investors blow themselves up:
Mistake #1: Buying High P/E at the Wrong Time
When growth is slowing
When the story is fading
When you’re paying future prices for past performance
Mistake #2: Buying Low P/E “Value Traps”
When earnings are declining
When returns are deteriorating
When the low multiple is actually warning you to run
Valuation is context.
P/E is a snapshot inside that context.
Get the context wrong → you get the trade wrong.
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The Biggest P/E Myths (That Will Get You Hurt)
The P/E multiple is the most abused metric in finance. When investors misunderstand it, they don’t just make mistakes; they blow themselves up.
Let’s dismantle the worst myths.
MYTH 1: “Low P/E Means It’s a Bargain”
This one destroys more portfolios than inflation, recessions, and CNBC combined.
A low P/E can mean:
earnings are about to fall
The business is structurally broken
The market sees a landmine you don’t
The stock deserves to be cheap
Take Credit Suisse.
Trading at a rock-bottom P/E before it imploded and got absorbed by UBS (WSJ coverage). Was it a bargain? No. It was a warning signal.
Meanwhile, bank investors in 2008 learned the same lesson: low P/E doesn’t equal value—it often equals danger.
If a P/E is low because the future is getting worse, congratulations—you’re not value investing, you’re catching falling knives.
MYTH 2: “High P/E Means It’s Overvalued”
A high P/E doesn’t mean a stock is expensive. It means the market expects growth.
Apple. Nvidia. Amazon.
These companies traded at high multiples for years—and made investors rich.
Counterintuitive Example: When a High P/E Was a Steal
Meta (late 2022)
The stock cratered. The metaverse spending was unhinged. Sentiment collapsed. Meta traded below 10x forward earnings.
The market misread the story.
Then Zuckerberg cut costs, refocused on core products, and the stock doubled within months.
High P/E isn’t dangerous. Wrong expectations are dangerous.
P/E Is About Vibes—But In a Very Real Way
Behind every trade is a human.
Behind every human is a bias.
Behind every bias is a perception of the future.
P/E is the market’s collective perception of future earnings—right or wrong.
So yes, it’s vibes. But vibes backed by cash flows, expectations, rates, risks, and psychology.
The trick isn’t memorizing the number. The trick is understanding why the number exists.
Is it low because earnings are about to collapse? Is it high because earnings will explode? Or is it just wrong because investors are emotional, scared, or euphoric?
That’s the real work.
The Bottom Line: Don’t Be a P/E Zombie
P/E is a tool—not a religion.
Low P/E is not always a value.
High P/E is not always a risk.
Compression is natural.
Expansion is earned.
And expectations, not numbers, drive returns.
Valuation is not physics. It’s psychology wrapped in math.
Next time someone confidently calls a stock “cheap” or “expensive” based solely on P/E, just smile.
They’re reading the vibes—not the fundamentals.
But now you know the difference.
Until next time,
Victaurs