Understanding Multiple Expansion: What Really Drives Valuation Upside?

Multiple expansion is often the unsung hero behind outstanding investment returns. Earnings growth, margins, and business quality matter but when a stock rerates from 15x to 25x earnings, it can turbocharge returns even if profits grow modestly.

But what really drives those valuation multiples higher? And more importantly-when is that expansion sustainable versus speculative?

Let’s unpack this with an institutional lens.

1. The Core Levers: Fundamentals Drive Durable Re-ratings

At its core, a valuation multiple-whether P/E, EV/EBITDA, or EV/FCF is simply a shorthand for what investors are willing to pay today for a dollar of future earnings or cash flow. As Damodaran emphasizes, multiples are “pricing” tools more than valuation in the strict DCF sense: they compress assumptions about growth, returns on capital, and risk into one number.

Long-term, the most durable expansions in multiples come from fundamental improvements in the quality of earnings, longevity of growth, and resilience of the underlying business:

• Sustainable Earnings Growth
  Predictable, compounding earnings streams attract premium multiples. Fidelity’s research highlights that stable EPS growth, particularly when paired with improving returns, is often rewarded with re-ratings.
• ROIC > Cost of Capital
  Morgan Stanley and McKinsey’s research shows that growth only adds value when it earns returns above the cost of capital. High ROIC businesses justify higher multiples; low ROIC firms growing rapidly destroy value.
• Margins and Efficiency
  Margin expansion signals operating leverage, management quality, and competitive advantage. This often catalyzes re-ratings even ahead of earnings.
• Balance Sheet Strength
  Low leverage and capital flexibility reduce downside risk-highly valued by investors especially in volatile macro backdrops.
• Moats and Business Quality
  Durable competitive advantages-pricing power, network effects, regulatory barriers support higher justified multiples. Pzena’s research shows that widening moats often precede multiple re-ratings, sometimes even before earnings catch up.

Key takeaway: The most justified multiple expansion occurs when growth, ROIC, and competitive strength move together.

2. What Multiples Miss: Why Context Matters

• Short-Term vs. Long-Term Disconnect
  The numerator (price/EV) reflects decades of cash flows, while the denominator (earnings/EBITDA) captures only a year. This mismatch means multiples often fail to reflect the magnitude and return on investments especially in situations where investments are heavy in the short term and cash flows are far out in the future.
• Rise of Intangibles
  With modern companies investing heavily in R&D, brand, and customer acquisition, earnings understate true economic investment. Adjusting for intangibles can materially change multiples-this is particularly relevant for tech companies.
• Capital Structure Distortions
  P/E can be distorted by leverage and tax differences, while EV/EBITDA adjusts for this. Sophisticated investors compare across both to avoid misleading conclusions.
• Peer Comparisons Are Risky
  McKinsey stresses that multiples only make sense relative to peers with similar ROIC, growth, and risk. Simply benchmarking against industry averages leads to false comfort.

 3. Market Forces: When Multiples Run Ahead of Fundamentals

Even when fundamentals are steady, multiples can swing sharply due to macro and market dynamics:

• Discount Rates & Duration
  Mauboussin shows that the “commodity P/E” is simply the inverse of the cost of equity. When interest rates fall, baseline multiples rise. Long-duration growth stocks (future cash flows far out) are far more sensitive to interest rate changes.
• Investor Narratives & Scarcity Premiums
  Stories like AI or EVs can drive multiples well beyond fundamentals. When only a few companies provide exposure to a theme, scarcity premiums emerge in the short term (and often correct over the medium to long-term)
• Cyclical and Crisis Distortions
  Multiples can be wildly misleading during shocks or deep cycles. McKinsey’s analysis of airlines during COVID showed EV/EBITDA ballooning simply because earnings collapsed, not because valuations truly soared.
• Bad Multiples for Good Companies
  Sometimes great businesses trade at uninspiring multiples simply because industry-wide convergence limits rerating potential. Premium multiples are rare and often short-lived.

4. How Investors Should Use Multiples

• Use multiples as a starting point, not an end—a shorthand for deeper DCF work.
• Always control for ROIC and growth when comparing across peers.
• Adjust for intangibles and capital structure to avoid distorted signals.
• Distinguish between justified multiple expansion (rooted in fundamentals) and speculative rerating (driven by sentiment or scarcity).

 Conclusion: The Real Edge in Multiple Expansion

Sustainable multiple expansion begins with fundamentals-returns on capital, durable growth, and competitive strength. But market narratives, discount rates, and sentiment amplify or distort those signals in the short run, sometimes dramatically.

The investor’s edge lies in knowing when multiples reflect genuine value creation versus temporary market exuberance. In other words: understand the story the multiple is telling and whether it’s grounded in economics or hype.