Path 10 · 6 min read
Valuation when P/E breaks
P/E is the first valuation ratio anyone learns and the only one a lot of readers ever use. It works well inside a peer group of mature, profitable, similarly-financed businesses — and it falls apart everywhere else. The fixes are not exotic; they are three other ratios with specific jobs.
This path takes them in the order of severity: first the headline ratio and its building block, then the rescue when earnings are negative, then the rescue when capital structure differs, then the adjustment that asks whether a high P/E is justified by how fast earnings are growing.
Start at the headline. Useful within a peer group, useless when the denominator is negative.
01P/E ratio
Price ÷ earnings per share. How many dollars investors pay today for each dollar of yearly profit.
The price-to-earnings ratio divides the current share price by the company's earnings per share over the last year. A P/E of 20 means investors are paying $20 for every $1 of annual profit.
High P/Es typically signal that the market expects strong growth; low P/Es can signal a value play or a business in trouble. Always compare a P/E against peers in the same sector, not across sectors. P/E breaks entirely when EPS is negative — for unprofitable growth companies, reach for price-to-sales or EV/EBITDA instead.
Live example
- NVDA49.2Growth premium — earnings expected to keep climbing.
- AAPL32.8Premium mega-cap — high quality, modest growth.
- GM6.4Cyclical, capital-intensive — market discounts the earnings.
Three different P/Es, three different stories. The number alone isn't the verdict — context is.
The denominator itself — and the line where GAAP and adjusted earnings most often diverge in tech.
02EPS (earnings per share)
Net income divided by diluted shares outstanding. The per-share slice of a year's profit.
Earnings per share is the company's net income divided by its diluted share count — the share count after every stock option, RSU, and convertible has been treated as already exercised. It is the denominator inside P/E and the headline number markets react to on earnings day.
GAAP EPS follows accounting rules to the letter; adjusted (non-GAAP) EPS strips out items management deems non-recurring — most often stock-based compensation. The gap between the two is where most accounting controversy in tech lives. Read both, and read alongside FCF margin for the cash check.
The rescue when EPS is negative. Read it within sub-sector, never across.
03Price-to-sales (P/S)
Market cap divided by trailing annual revenue. The valuation ratio that still works when a company has no earnings to divide into.
P/S is market cap divided by revenue over the last twelve months — what investors are paying per dollar of sales. It is the valuation ratio of choice for growth-stage companies, where earnings can be negative or trivially small and P/E becomes meaningless.
Read it within a sub-sector, not across: software businesses routinely trade at 10–20× sales, hardware at 2–5×, banks below 3×. A 20× P/S on a SaaS business in a hyper-growth phase reads as expensive but not absurd; the same number on a hardware company is a statement.
The rescue when companies in the comparison have very different debt loads, tax rates, or depreciation.
04EV/EBITDA
Enterprise value divided by EBITDA. The cleaner cross-company valuation ratio because it includes debt and ignores capital structure and tax differences.
Enterprise value (EV) is market cap plus debt minus cash — the price an acquirer would have to pay for the whole business, not just the equity. EBITDA is earnings before interest, tax, depreciation, and amortisation. Their ratio answers "how many years of pre-financing operating profit am I paying for the whole company?"
EV/EBITDA is preferred over P/E when companies in the same comparison have very different debt loads (a heavily indebted firm flatters P/E by inflating interest expense out of net income), different tax rates (multinational vs. domestic), or heavy depreciation (capital-intensive vs. asset-light). Most tech screens use it alongside P/E rather than instead of.
And the adjustment that asks whether a high P/E is being justified by faster earnings growth.
05PEG ratio
P/E divided by expected earnings growth, in percent. A way to ask whether a high P/E is justified by how fast earnings are growing.
PEG divides the P/E ratio by the company's expected annual earnings growth rate in percent. Peter Lynch popularised the heuristic that a PEG of 1 is fairly priced — a P/E of 30 on a company growing at 30% — while a PEG under 1 is structurally cheap and over 2 is structurally expensive.
The heuristic breaks at the extremes. A company growing earnings at 80% won't grow at 80% forever, so a PEG of 0.5 on that base doesn't mean what it would on a 15% grower. Treat PEG as a screen, not a verdict — useful for sorting a peer list, not for picking a stock outright.
Four ratios, four jobs. P/E is the first read; P/S is the rescue when earnings don't exist; EV/EBITDA is the rescue when capital structure differs; PEG is the adjustment for growth. None of them is a verdict on its own — they are the screen, not the call.
Quick check
Did it stick?
3 questions · pass at 3/3.
1. Which valuation ratio still works when a company has negative earnings?
2. EV/EBITDA is preferred over P/E when…
3. A PEG of 0.5 on a company growing earnings at 80% per year is…