The Most Misunderstood Metric In Finance - The P/E Multiple

So you fancy yourself a valuation expert?

If I had a dollar for every time someone threw around a P/E multiple like it was the gospel truth, I’d have another island in the Carribean (okay … I’d have my first one). The price-to-earnings (P/E) ratio is everywhere—flashed on CNBC, jammed into analyst reports, and worshipped by retail investors who think they just found the next ten-bagger because some stock is trading at 5x earnings.

Here’s the problem: most people don’t actually understand what P/E means. They treat it like a standalone buy/sell indicator when, in reality, it’s just a shorthand, a snapshot of a company’s valuation at a single point in time. Used wisely, it’s a useful tool. Used recklessly, it’s financial napalm.

And after reading this you won’t sound like the clowns pretending that they can value a Company by taking Earnings, applying some P/E multiple, and acting as if they’ve split the first atom (no shade to Ackman’s latest Fannie/Freddie thesis).

What is the P/E Ratio, Really?

Literally, it’s the Company’s Market Price divided by Earnings Per Share. It tells you how much investors are willing to pay for each dollar of a company's earnings. Simple enough, right?

You can also think of it as the number of years it would take for an investor to recoup their investment through earnings, assuming earnings remain constant and there is no growth or decline. Quite a big if.

But here’s the key point most people miss: P/E is not a measure of value—it’s a measure of price. It doesn’t tell you what a company is worth; it tells you how the market is pricing its earnings at this moment. Stocks with the same P/E can have vastly different futures, because valuation is about cash flows, returns, and competitive advantage—not just a multiple on earnings.

Using this line of thinking, a P/E of 20 means it would take 20 years of current earnings to fully recover the investment if earnings remained unchanged. A P/E of 10 suggests a 10-year payback period, which could indicate either lower expected growth or a potential undervaluation. Conversely, a high P/E, such as 40x earnings, implies that investors anticipate significant future growth; otherwise, waiting 40 years to recoup the investment would be unappealing—or just plain dumb. But in reality, earnings fluctuate, companies reinvest, and shareholders receive returns through dividends and buybacks, often shortening the actual payback period.

To summarize, a high P/E means investors expect strong future earnings growth. A low P/E suggests lower growth expectations, possible risk, or just a company in decline. A boomer company, if you will—slow, predictable, boring.

That’s it. It’s not some mystical number that can predict the future. It’s a reflection of market expectations at this moment. And when I say market expectations, I really mean human expectations—because behind every trade, a human (even one programming an algorithm) decides to buy or sell at this price, at this EPS, at this P/E multiple.

And since humans are emotional, fallible, and at times illogical, the P/E multiple isn’t perfect truth—it’s just a reflection of human perception of the truth.

Sorry, Neo, didn’t mean to go full Oracle on you—but you needed to hear it. P/E is an opinion disguised as a number.

What P/E Tells You (And What It Doesn’t)

Michael Mauboussin is a valuation wizard, a behavioral finance guru, and basically the finance world’s Yoda. He’s spent decades dissecting how markets work, how investors think (and often misthink), and how to separate actual value from noise. Formerly the Chief Investment Strategist at Legg Mason, now a top researcher at Morgan Stanley, Mauboussin is the guy fund managers, hedge funds, and deep-cut CFA nerds worship. The moment he drops a new paper, they come running like Pavlov’s dogs when he rings the bell—frothing at the mouth for another dose of valuation wisdom.

One of his biggest insights? P/E isn’t just one number—it’s two stories in one.

First, there’s the steady-state value—what the business is worth if it simply maintains its current earnings forever. Simple enough.

Then, there’s future value creation—the premium investors are willing to pay based on growth expectations.

This is where people get wrecked. They see a stock trading at 40x earnings and assume it’s expensive. But let’s put numbers to it:

Company A trades at 40x earnings, with $1 per share in earnings. Investors are effectively paying $40 per share, betting that earnings will double in five years. If earnings reach $4 per share, the P/E drops to just 10x assuming no price change. If growth keeps compounding, the stock could justify an even higher valuation over time.

Company B trades at 10x earnings, also with $1 per share in earnings, so it’s priced at $10 per share. But if those earnings start shrinking, suddenly that “cheap” stock isn’t cheap at all. If earnings drop to $0.50 per share, the P/E multiple jumps to 20x overnight—a multiple expansion for all the wrong reasons. And since stock prices follow earnings, that 10x “bargain” is now a falling knife.

The key lesson is, a high P/E is only “expensive” if the company fails to deliver the expected growth. And a low P/E isn’t a bargain if the business is in decline—it’s just a value trap in disguise.

Bank investors know this better than anyone. They’ve been bag-holding the lowest-multiple sector in the U.S. for years, constantly buying some heap of trash at 5x earnings while mumbling “it’s cheap!” as the stock bleeds out and earnings leak lower, and lower and lower.

Don’t be that guy (hint: I’ve been that guy).

The Role of Growth and Cost of Capital in P/E (Hint: It’s Everything)

If Michael Mauboussin is the Yoda of valuation, then Aswath Damodaran is its Gandalf—a walking, talking human database of valuation knowledge who can break down any financial model like a machine. As a professor at NYU Stern, Damodaran has spent decades teaching, writing, and roasting bad finance takes on his blog. He’s famous for making valuation accessible—whether it’s breaking down how to value companies like Tesla, explaining why some growth stocks deserve sky-high multiples, or reminding people that "intrinsic value" isn’t a religious belief, but a function of assumptions.

And when he drops a new paper? Hardcore CFA nerds sprint to their screens, screaming “Wake up babe, the latest Damodaran just dropped!” The man could write a 50-page report on the valuation of canned tuna, and the valuation geeks would still be foaming at the mouth.

One of Damodaran’s biggest insights? P/E is as much about future growth as it is about earnings today. A company’s P/E multiple is driven by two major forces:

Growth Rate – Faster-growing companies deserve higher P/E multiples. The reason? Compounding. If a company reinvests earnings at a high return, it should trade at a premium because those future earnings are worth more today.

Cost of Capital – If a company’s growth is funded cheaply, its future cash flows are more valuable, which boosts its P/E. Companies with high cost of capital (think distressed firms or risky sectors) will naturally trade at lower P/E multiples because their future earnings are discounted more aggressively. This is a big point.

On the cost of capital, you should know that the inverse of P/E (Earnings Yield = E/P) is not the same as Cost of Capital (WACC), but it can be used as a rough shorthand. Earnings yield tells you how much profit investors get per dollar invested, while WACC represents the company's blended cost of financing, including both debt and equity. The cost of equity is typically calculated using the Capital Asset Pricing Model (CAPM) including risk free rates, equity risk premium, and beta.

Right now, with the 10-year U.S. Treasury yield around 4.3%, an average equity risk premium of 5-6%, and many stocks having a beta between 1.0-1.2, most companies have a cost of equity in the 9-11% range. Meanwhile, WACC blends this with the after-tax cost of debt, which varies depending on credit risk and interest rates but is typically lower than equity costs. Debt costing less than equity lowers all in WACC typically.

If a company’s ROTCE/ROE is higher than WACC or Earnings Yield, it’s likely creating value—generating more return than it costs to fund itself. If however future returns on equity are lower than WACC, it may be destroying value. While E/P can serve as a quick proxy for cost of capital in equity-heavy firms, WACC gives the full picture by factoring in debt and equity together. But the key is are you growing profitably or with the potential for future profit? Or are you just growing at low margins and destroying value?

Amazon vs. General Motors: The P/E Illusion

Let’s get back to the P/E illusion and put this into numbers.

Amazon in the early 2000s traded at insane P/E multiples—sometimes over 100x earnings. On the surface, that looks like a ripoff. But if you looked under the hood, Amazon’s revenue was doubling every 2-3 years, and every dollar it reinvested was turning into more dollars at a ridiculous rate. Say Amazon had $1 per share in earnings at a 100x P/E—investors were paying $100 per share. But if earnings quadruple in five years to $4 per share, that same stock is now trading at 25x earnings without the price moving an inch. And if the growth keeps compounding? That high P/E wasn’t expensive—it was a steal. The key was seeing that if Amazon wanted to it could convert revenue into earnings at some point in the future.

General Motors, on the other hand, could trade at 5x earnings forever. Let’s say GM earns $5 per share and trades at $25—a 5x P/E. Looks dirt cheap, right? Except GM’s earnings aren’t compounding; they’re flatlining or shrinking over time. If earnings drop to $4 per share, suddenly that cheap 5x P/E turns into 6.25x overnight—and the stock will probably tank to keep the multiple in check.

Another key lesson, high P/E is only "expensive" if the company fails to deliver the growth implied by the multiple. And low P/E isn’t a bargain if the business is a melting ice cube—it’s just a value trap in disguise. But the most important thing is realizing how earnings can change into the future. So you also should know at least a little about how management thinks about this challenge before blindly using P/E.

Why High-Growth Companies Trade at High P/Es (And Then Fall Over Time)

Growth stocks almost always command high P/E multiples early on, but as they mature, their P/E ratios decline. This isn’t some grand conspiracy—it’s just basic financial mechanics.

Early-stage companies reinvest heavily, often sacrificing short-term earnings for long-term dominance. Investors reward this reinvestment by assigning a high multiple, betting on future earnings power rather than current profits. Top line growth shifts to bottom line focus.

Mature companies slow down, earnings growth stabilizes, and the market no longer assigns the same sky-high multiple. Not because the company is bad, but because the law of large numbers kicks in—it’s exponentially harder for a $500B business to grow at 30% annually than a $5B one.

Damodaran’s research shows that companies in the top 10% of revenue growth tend to have P/E ratios twice as high as the market average. But within five years, that multiple often contracts by 30-50% as growth slows—even for great businesses.

Mauboussin backs this up, emphasizing that businesses with high returns on incremental invested capital (ROIIC) can maintain higher multiples longer—but eventually, even the best firms see their P/E shrink. Think of this pull downward as the finance equivalent of gravity. A force so powerful only Nvidia can overcome it (at least in the short term).

Case Studies: When P/E Compression Hits Even the Best Stocks

Microsoft in the 90s: At its peak in the late 90s, Microsoft traded at 50x earnings as it dominated the personal computing revolution. But as growth naturally slowed in the 2000s, even with strong profitability, its multiple compressed to the 20-30x range. The business didn’t collapse—its valuation just matured.

Amazon (2000s-2020s): In the early 2000s, Amazon traded at insane triple-digit P/Es, justified by explosive growth in e-commerce. But by the late 2010s, as revenue growth normalized (from 30-40% annually to 10-20%), its multiple compressed. Even after reaching cloud dominance with AWS, Amazon’s P/E dropped from 100x+ to 30-50x.

Tesla (2020-Present): In 2020-21, Tesla’s P/E surpassed 1,000x earnings, fueled by expectations that it wasn’t just a car company, but an energy-tech juggernaut. But as sales growth slowed and competition increased, the multiple collapsed to sub-70x—still premium, but nowhere near its speculative highs.

Apple (2010s-Present): In 2010, Apple traded at 10-15x earnings, despite dominating smartphones. Why? The market saw it as a hardware company with cyclical demand. But as services revenue exploded and gross margins expanded, the multiple rose above 30x—a rare example of multiple expansion rather than compression.

Why This Matters

Understanding this life cycle is the key to not overpaying for growth stocks at the wrong time or panic-selling them when multiples compress naturally.

Buying high-P/E stocks? Make sure the growth justifies the multiple.
Holding a maturing company? Expect the P/E to decline, even if earnings stay strong.
Think low P/E = value? Not always—some companies deserve low multiples (see IBM, GM, AT&T).

Valuation is a moving target. The key is knowing where a business is in its cycle—and paying accordingly.

And let’s be real—P/E isn’t some universal law of physics. It’s just a price. A number made up by millions of investors voting with their trade tickets, deciding what they think earnings are worth right now.

P/E is a collective bet on the future—millions of us buying and selling, guessing where the world is headed, trying to make sense of it as we go. It is subjective and objective because price today is a function of people’s perceptions of price tomorrow, which is both subjective and objective.

The Biggest P/E Myths (That Will Get You Burned)

“Low P/E Means It’s a Bargain”

Nope. A low P/E can be a trap, signaling declining earnings, high risk, or outright capital destruction. Ask anyone who loaded up on “cheap” bank stocks in 2008—they weren’t getting value, they were catching falling knives.

Counterintuitive Insight: When Low P/E = Warning Sign?

Take Credit Suisse ($CS) before its collapse in 2023. It was trading at a rock-bottom P/E, but that wasn’t a sign of value—it was a flashing red light. Earnings were weak, its balance sheet was crumbling, and the business was structurally flawed. Anyone who bought it for “value” got wiped out when regulators forced it into a fire-sale to UBS.

“High P/E Means It’s Overvalued”

Wrong again. A high P/E doesn’t mean expensive—it means investors expect big growth. Apple, Amazon, Nvidia—companies that crushed the market—have all traded at high P/E multiples for years. And rightly so.

Counterintuitive Insight: When High P/E = A Steal?

Look at Meta in late 2022. The stock had collapsed on fears of slowing ad revenue and Zuck’s metaverse money pit. At its lowest point, it traded at under 10x forward earnings—a ridiculous multiple for a cash-generating machine. The market completely misread its ability to cut costs and refocus on profitability. Once Zuck pulled the plug on reckless spending, the stock doubled in months, proving that a “cheap” P/E was actually a massive buy signal.

The Bottom Line: Don’t Be a P/E Zombie

P/E isn’t a cheat code for instant riches. It’s just a tool—one that tells you what the market’s willing to pay for a company’s earnings.

Blindly chasing low P/E stocks? Congratulations, you're now holding the bag on dying businesses.

Afraid of high P/E stocks? You just passed on Amazon, Nvidia, or Apple before their meteoric runs.

I talk a lot about vibes in investing—how millions of data points, metrics, and opinions blend into the intangible "feel" for a company. P/E is exactly that: a distilled vibe, a snapshot of all these conflicting expectations and predictions, both terrifying and beautiful.

High P/E, low P/E, it's all vibes. The trick is understanding which vibes are worth betting on.

Now you know. And knowing, as always, is half the battle.

Next time some titan of finance confidently declares a stock is “cheap” or “expensive” based solely on its earnings multiple, you'll quietly smile knowing they're riding the vibes, too.

Until next time,

Victaurs