Fundamental analysisModule 5, lesson 25 of 48
Why sectors are valued differently
Why growth, returns on capital, cyclicality, debt and regulation make some sectors trade at higher multiples than others, and which measures suit which sectors.
In this lesson
- Explain the main reasons valuation multiples differ between sectors.
- Link high returns on capital and durable growth to higher multiples.
- Explain why cyclical and regulated sectors usually trade at lower multiples.
- Match valuation measures to the sectors they suit.
Builds on
- Comparing valuations with history and peersSector differences explain why peer comparisons must stay within similar businesses.
- Return on capital employed (ROCE)Returns on capital are one of the main drivers of sector multiples.
On this page
In simple terms
Look at the P/E ratios of companies in different sectors and you will see enormous differences. Consumer goods companies may trade at 50 times earnings, banks at 15, metal producers at 8. Beginners often conclude that the high-multiple sectors are overvalued and the low-multiple ones are bargains. Usually, the differences reflect real differences in the businesses.
A multiple is a price for today's profit. What investors will pay depends on how much profit they expect in future, how certain it is, and how much capital is needed to produce it.
The main drivers
Growth and how long it lasts. A sector expected to grow profits steadily for many years deserves a higher multiple than one expected to grow slowly or not at all.
Returns on capital. A business earning 40% on its capital can grow while still producing lots of cash; one earning 10% must reinvest most of its profit to grow at all. The incremental returns lesson explains why this makes the high-return business worth more for the same profit.
Stability. Predictable earnings are worth more than volatile ones. Consumer staples, which people buy in good times and bad, usually trade at higher multiples than cyclical businesses.
Debt. Heavily indebted sectors carry more risk for shareholders, which lowers equity multiples.
Regulation. Regulated utilities may have steady earnings but capped returns, which limits their multiples. Sectors exposed to sudden regulatory changes carry extra risk.
Disruption risk. Sectors facing technological change may trade at low multiples because investors doubt their profits will last.
Worked example: Three made-up sectors
| Consumer staples | Private banks | Metals | |
|---|---|---|---|
| Typical ROCE or ROE | 40%+ ROCE | 15% to 18% ROE | 8% to 25% ROCE, swinging with the cycle |
| Earnings stability | High | Moderate | Low |
| Growth runway | Long, steady | Long, tied to credit growth | Tied to cycle |
| Typical P/E | High | Moderate | Low at peaks, very high or meaningless at troughs |
These are illustrative patterns, not current figures. They show how the economics of each sector line up with its typical valuation.
Matching the measure to the sector
| Sector type | Measures that suit it | Why |
|---|---|---|
| Consumer, software, services | P/E, EV/EBIT, free cash flow yield | Asset-light, steady profits |
| Banks and lenders | P/B with ROE, ROA | Assets are financial; debt is the raw material |
| Insurers | P/B, embedded value for life insurers | Profits emerge over long contract lives |
| Capital-intensive industry | EV/EBITDA, EV/EBIT | Different debt and depreciation |
| Cyclicals and commodities | Multiples of normalised earnings, EV per unit of capacity | Earnings swing through the cycle |
| Real estate developers | Net asset value, cash flows from projects | Profit recognition is lumpy |
The sector lessons in this path cover banks, insurers, commodity businesses and others.
When sector differences are not justified
Sector multiples can also reflect fashion. Sectors in favour can trade far above what their growth and returns justify, and unfashionable ones far below. The test is the same as for any company: do the growth, returns and stability justify the multiple? If a whole sector's multiple implies growth no realistic business could achieve, it may be expensive however good the companies are.
Why it matters
Understanding why sectors differ prevents two errors: dismissing high-quality businesses as "too expensive" because their multiples are above the market's, and buying low-quality businesses because they are "cheap". It also tells you which valuation tools to use for which companies.
Limitations
The drivers above explain typical differences, but each sector contains companies of very different quality. Sector boundaries are fuzzy, and companies change sectors as their businesses evolve. Typical multiples shift with interest rates and market moods, so any rule of thumb about "normal" sector multiples goes out of date.
Common mistakes
- Comparing a company's P/E with the market average instead of with its sector.
- Assuming every sector should trade at the same multiple.
- Using P/E for banks or EV/EBITDA for insurers.
- Ignoring the possibility that a whole sector is in or out of fashion.
Try it yourself
- Choose one listed company from each of three sectors: consumer goods, banking and metals.
- Find each one's P/E, P/B and ROE or ROCE.
- Use the P/E ratio calculator to check the P/E figures from price and EPS.
- Write a sentence for each explaining its multiple in terms of growth, returns and stability.
Key takeaways
- Multiples differ between sectors mainly because of differences in growth, returns on capital, stability of earnings, debt and regulation.
- Businesses that earn high returns on capital and can reinvest for many years tend to trade at high multiples, because each rupee of profit is worth more.
- Cyclical, commodity and heavily regulated sectors usually trade at lower multiples because their earnings are less predictable or their returns are capped.
- There is no reason for every sector to trade at the market's average P/E. Compare companies within their sector.
- Use the measure that suits the sector, such as P/B for banks, EV/EBITDA for capital-intensive businesses, and normalised earnings for cyclicals.
Check your understanding
Try the numbers yourself
- P/E ratio calculatorHow do I calculate a company's P/E ratio?
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Terms used in this lesson
- P/E ratio
- The price-to-earnings ratio, the share price divided by earnings per share, showing how much investors pay for each rupee of yearly profit.
- Return on capital employed
- Operating profit (EBIT) divided by the capital provided by shareholders and lenders together, a measure of business quality little affected by debt.
- Cyclical business
- A business whose demand, prices and profits rise and fall with the economy or its industry's supply cycle, such as metals, cement or autos.
- Price-to-book ratio
- The share price divided by book value per share, or market capitalisation divided by shareholders' equity.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.