RATIONAL REFLECTIONS
By Bell Institutional
The Shortcomings of Using Ratios in Valuation
The best time to use a valuation ratio to value the market or any company within it is very rarely, or better yet, never. Valuation ratios such as price-to-earnings (P/E), price-to-book (P/B), or enterprise value to EBITDA (EV/EBITDA) are ubiquitous in finance and promise a quick verdict on “cheap” or “expensive.” Yet, they often deliver optical illusions.
At its core, a valuation ratio is nothing more than the market’s embedded expectations divided by a single, noisy accounting denominator. It cannot substitute for the disciplined forecasting of growth, reinvestment needs and risk the foundational pillars of discounted cash flow (DCF) valuation.
Relative Valuation is Pervasive
Relative valuation dominates Wall Street and the investing public. In our view, approximately 90% of equity research reports from Wall Street firms rely on valuation ratios (multiples), and more than 70% of merger and acquisition (M&A) activity uses similar rules of thumb. Multiples are not only common, but also often drive final investment decisions and the price targets investors see on TV.
To perform relative valuation, one must:
1. Identify comparable assets and obtain their market prices.
2. Convert these prices into standardized multiples (absolute prices cannot be compared).
3. Compare the target asset’s multiple to those of peers.
4. Conclude whether the asset is overvalued or undervalued.
Why is relative valuation so pervasive? It is fast, forgivable, and frictionless the investing equivalent of fast food. Anyone can do it!
“If you are going to screw up, make sure you have lots of company.” — Former portfolio manager
Why Do Valuation Ratios Fall Short?
Ratios fail for many reasons, but three stand out:
1. Ratios Ignore the Timing and Magnitude of Growth: We firmly believe that price is nothing more than future expected cash flows discounted back to the present no more, no less. The commonly cited trailing P/E ratio, however, divides price by only the last four quarters of earnings a finite, backward-looking snapshot. The concept is the same for the forward P/E ratio, except the estimated next four quarters’ earnings are used.
Consider this deconstruction of the P/E ratio:
Identical P/E ratios can mask radically different fundamentals. A high P/E may signal robust longterm growth (e.g., Amazon in the 2010s) or over-optimism. A low P/E may reflect temporary distress or structural decline.
To further illustrate, see the example below¹ where all three companies trade for $100 a share. Which would you choose? Try not to cheat!
Company A is a steady compounder with an impenetrable moat that will continue to grow earnings consistently for the next 10 years. Company A’s forward-looking multiple is much lower than Company C’s, but higher than Company B’s.
Company B boasts a weak moat and quickly matures. Its high-growth period is short lived. Company B trades at the lowest forward P/E ratio.
Company C is a high-flying tech stock with earnings that are lower than the earnings of companies A and B ($2.50 vs $5.00). It is developing a new product that doesn’t take off until year five. Company C boasts the highest average earnings growth rate and trades at an elevated multiple.
1. Company A is the winner as it can fend off competition and maintain its growth rate for an extended period. However, many “value” investors who use valuation ratios would have chosen Company B. The forward multiple is lower and the near-term earnings profile looks great. The stock is a bargain, right? Our intrinsic valuation (DCF analysis) would say not so fast. DCF analysis accounts for timing and magnitude of cash flows; multiples do not.
2. Ratios Are Vulnerable to Non-Stationarity: A critical concept in time-series analysis is stationarity. Data are stationary when their statistical properties (mean, variance, etc.) remain constant over time, with no trends or seasonality. The basic idea is that for an average to be comparable over time, the statistical properties of the population must remain the same.
The S&P 500 of 2025 is tech-heavy, profit-rich, and globalized, a far cry from the industrial-heavy 1960s. Valuation ratios assume today’s market is comparable to the past. It is not. What investors are really doing is comparing apples to oranges.
To further the point, research over 125 years shows no statistically significant relationship2 between starting P/E and subsequent 12- or 24-month returns. The P/E ratio offers little predictive power over typical investment horizons.
3. Ratios Are Distorted by Accounting Practices: All public companies follow the same accounting rules in theory. In practice, fidelity varies. CEOs with EPS-linked bonuses may engage in:
• Channel stuffing
• Special Purpose Vehicles (or SPVs – think Enron)
• Aggressive revenue recognition
• Debt-funded buybacks
• One-time gain harvesting
• Moreover, GAAP accounting rules treat research and development (R&D) and marketing as operating expenses, even though they are growth investments. This contrasts with capital expenditures (capex) that are capitalized on a company’s balance sheet and amortized over a period of time. A manufacturing firm building a new factory and a software company paying R&D wages are economically identical: spend today, earn tomorrow. Yet, tech firms are penalized in earnings-based ratios. This again leads to an apples to oranges comparison.
An earning is just an accounting construct. You can’t eat it. You can’t take it home.
Conclusion
Ratio-based valuation is seductive. It is fast, intuitive, and forgivable (it was the market, not me!), but speed is not insight. Identical multiples can conceal divergent futures; historical averages can mislead in evolving markets; and accounting figures can be gamed or structurally biased.
Investors who rely on ratios risk confusing price with value. True valuation demands an analysis of growth, reinvestment needs, and risk. Only then can one distinguish a durable compounder from a fleeting breakout, or a bargain from a value trap.
Keeping the Feedback Loop Open
It is entirely possible that you disagree with a variety of the assumptions in this article. Rather than dismiss alternative analyses as wrong, we are better served by keeping our feedback loop open. If you would like to share your opinion and/or critique ours, please feel free to share your thoughts. One of the great
aspects of investing is that if you get something wrong, you always have the opportunity to change it. Refusing to change a narrative, just because it is yours, is nothing more than hubris.
Jordan Bancroft, CFA, CAIA® VP/Portfolio Manager Fargo
jbancroft@bell.bank
End Notes
¹We incorporate the following assumptions:
• Discount rate of 8.5%
• Terminal growth rate of 4% (similar to current 10y UST), which is a proxy for nominal GDP growth
• Mid-point method to account for even cash flows throughout each year
• For simplicity, we assume $1 in earnings is equal to $1 in cash flow ²Kenneth L Fisher and Meir Statman, “Cognitive Biases in Market Forecasts: The Frailty of Forecasting,” The Journal of Portfolio Management 27, no. 1 (Fall 2000): 72-81.
Disclosures
This communication reflects the personal opinions, viewpoints and analyses of the Bell Institutional Investment Management (BIIM) employees providing such comments, and should not be regarded as a description of advisory services provided by BIIM or performance returns of any BIIM client.
The views reflected are subject to change at any time without notice. Nothing in this communication constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BIIM manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.