Distortion in earnings multiples analysts often use earning multiples in trading comps valuation and earnings multiple uses an earnings metric as a value driver. For example an EV to ebit multiple or a PE ratio as shown here. When we're using earnings multiples in our analysis, the earnings metric must be a good or strong predictor of future cash flows to investors. If there is not a strong relationship between earnings and future investor Returns, the multiple will be distorted and will mislead our valuation. Although we can potentially use any earnings metric in our multiples. We need to think carefully about which earnings metrics are distorted in certain situations as this allows us to reduce our alliance on those multiples in those situations. Let's have a look at two common examples of how a multiple can be distorted. The first example is where there is a temporary reduction in a company's earnings. Let's say this occurs because the company is currently being restructured. This won't have much of an impact on the company's valuation because it's just a temporary contraction in earnings. But the value driver that's the denominator in our multiple is going to be lower. The company's multiple will therefore be higher than peers. So this makes the company look expensive compared with comparable companies, but this is just a distortion of the multiple rather than reflecting that the company is generating higher growth higher returns or lower risk. A second slightly trickier example is what happens if certain costs are ignored by the value driver which are relevant for future cash flows. Let's say this occurs because we decide to use an EV to ebitdar multiple instead of EV to ebit. This doesn't have any impact on the value number as we're still using EV as the numerator but the value driver that's the denominator in our multiple is higher because ebitda is before depreciation and amortization costs. The company's easy to ebitdar multiple is therefore lower than its EV to ebit multiple, which is no great surprise. But what if this company has much higher capex needs than its peers and that's reflected in the company having much higher depreciation and amortization than its peers. By using ebitda as a value driver we're effectively ignoring important cost differences between this company and its peers and ebitda is an inflated number. The company's EV to ebitda multiple will therefore be lower than peers. So this makes a company look cheap compared with comparable companies on an EV to ebitda basis. But again, this is just a distortion of the multiple reflecting the fact that ebitsar is not a good value driver if we're comparing companies with different capex needs. Analyzing and comparing different multiples and looking at the trends in multiples can help us to understand what is reflected in each multiple. Importantly this helps us to identify whether a company having a higher or lower multiple than its peers is a result of differences in expectations and growth returns and risk or is the result of distortion in that multiple.