Multiples Valuation: Importance, Methodology, Advantages, and Disadvantages
Updated: Oct 14, 2022
"Multiples" is shorthand for "multiples of earnings", which was first put forward by the P/E ratio (price to earnings) and has since evolved into other multiples such as EV/EBITDA, EV/Sales, etc. These are used to help investors determine the relative value of companies by comparing their relative levels of profitability and growth potential.
The multiples valuation method is a technique used to estimate the value of a company. It can be used with individual companies or groups of companies, like an industry sector or market segment.
The sections below explain what these multiples are, why they are used by analysts, and how they are calculated.
Table of Contents
What is the Multiple Valuation Method?
A multiple is a ratio used to compare similar companies or similar characteristics of different companies. The more similar the two companies are, the more useful (and accurate) the multiple is likely to be. The right selection of comparable companies is crucial for a successful multiples valuation.
The multiples approach is based on the theory that the value of a company (or asset) can be estimated by applying average price-to-value ratios from comparable transactions.
Multiples valuation is often useful to estimate value in a situation where there are not enough data points available to produce an accurate DCF. This is because, unlike DCF models, multiples do not require detailed financial forecasts.
To calculate comparable company multiples, you will need actual earnings, projected earnings, and revenue data for a set of comparable companies. You can use either industry or peer group averages or you can calculate the average. In other words, it's a way to determine what price a buyer would pay for a property based on its comparable sales.
The multiple valuation method is based on the principle that two similar properties will sell for approximately the same price in similar economic conditions. This means that if you're trying to determine what price someone would pay for your house, you could take the average sale price of homes in your area and multiply it by 2 or 3 times to get an idea of what your house might sell for.
Different Types of Multiples
The multiples valuation method is a technique that uses multiple ratios to value the business. These ratios are compared with industry averages to derive the value of the business. It is used by investors when they want to compare one company’s performance with another company’s performance. The multiples used are typically price-to-earnings (P/E), price-to-sales (P/S), price-to-book (P/B), enterprise value-to-earnings ratio, enterprise value-to-sales ratio, and enterprise value-to-EBITDA.
P/E ratio (price-earnings ratio) - compares a company's share or stock price to its earnings per share (EPS).
There are two types of multiples: LTM (Last Twelve Months) and NTM (Next Twelve Months). The LTM P/E ratio refers to the most recent 12 months' earnings divided by the current share price. The NTM P/E ratio refers to the consensus estimate for the next 12 months' earnings divided by the current share price.
The P/E ratio is perhaps the most popular multiple because it's easy to understand and compare across industries and periods.
For example - if Company A has a stock price of $10 and EPS of $1, its P/E ratio would be 10 (stock price)/1 ($ EPS). The higher this number is above 1, the more expensive the stock is conversely, a low P/E indicates that investors think that shares are undervalued.
Price to Book (P/B) Ratio: Price to book value is the ratio of a company's share price to its book value.
Price to book value can vary significantly from industry to industry depending on how profitable companies are and how much cash they have on hand relative to their liabilities. For example, a high price to book value stock in an industry with low profitability may indicate that the market expects more growth in the future than a low price relative to book value stock in an industry with high profitability.
Price to Sales (P/S) Ratio: The price to sales ratio is calculated by dividing the market capitalization by the total sales of 12 months or annual revenue. The higher the number, the more expensive the stock is relative to its peers. The lower the number, the cheaper it is relative to its peers.
The price-to-sales ratio is a great way to compare companies that operate in different industries or sectors. It allows investors to compare companies based on their performance rather than on their growth rates alone.
Enterprise Value-to-EBITDA (EV/EBITDA) Multiple - compares a company's enterprise value (EV) to either its earnings before interest, taxes, depreciation and amortization (EBITDA) or sales. Measures how much investors are willing to pay for each dollar of operating cash flow before paying interest and taxes.
Enterprise Value-to Sales Ratio (EV/S) Multiple - compares a company's enterprise value (EV) to sales. Measures how much investors are willing to pay for each dollar of sales that the company generates from its operations.
Enterprise Value-to-Earnings Ratio (EV/E) Multiple -compares a company’s enterprise value (EV) to earnings. Measures how much investors are willing to pay for each dollar of a company's earnings.
Why Multiple Valuation Method is Important?
The multiples valuation method is important because it provides a relative comparison of valuations between companies and industries. It also helps investors determine whether they should buy or sell their existing positions in any given stock based on its current multiples relative to other stocks within the same industry or market index.
How to Perform Multiple Valuation Method With Example?
The multiple valuation method is a way of determining the value of a company by multiplying its earnings or cash flow by a certain number. This number is usually based on an industry average, which makes it easy to compare companies.
Taking the average = (12.0+12.3+9.8+12.6+12.4)/5
= 11.82
We can see that the Canadian Imperial Bank is trading at a discount as compared to other banks. Now, we can use this average multiple to calculate the value of our business by multiplying it by its earnings or cash flow, or revenue or earnings before interest, taxes, depreciation, and amortization (EBITDA).
Advantages of Multiple Valuation Method
The main advantage of this method is that it allows investors to make comparisons between companies regardless of their size or market capitalization. It also allows investors to make comparisons across industries which may not be possible through other methods.
The multiple valuation method is particularly useful when valuing high-growth companies with several divisions because it allows investors to see how much growth potential there might be in other divisions besides those currently being discussed in public forums.
It provides an objective basis for determining fair value in situations where market prices are not available or reliable. It makes it easier to defend the value conclusion when an appeal or lawsuit is filed against your opinion of market value.
Multiple approaches provide more information about a property's value, which can give lenders a better idea of how much risk they're taking on when they make a loan.
The Multiple Valuation Method provides more accurate valuations than single valuation methods because it considers both quantitative and qualitative factors. This means that you'll get a more holistic view of an asset's value when you use this method.
Disadvantages of Multiple Valuation Method
The main disadvantage of the multiples valuation method is that it requires several assumptions to be made about the future, and these assumptions may not be accurate.
The potential for error increases when you use multiple valuation methods. This can be especially true when you're dealing with companies that are experiencing rapid growth or undergoing significant changes in their business model or management team.
It's time-consuming to calculate multiple valuations for each asset being valued. The process of determining a company's value can be quite complex, and it involves considering a variety of different factors. In some cases, an investor may even have to spend weeks or months researching a given company before they can come up with a final valuation.
It ignores differences in capital structure and idiosyncratic risks among companies being compared.
Day-to-day changes in a stock price may not accurately reflect long-term value or performance trends for the average investor.
Conclusion
Considering this valuation method, we can easily see how investors consistently pay over the value price for a company that is considered a leader in their industry. However, one of the most important components of this valuation method is the ability to consolidate multiples that are not related to each other. For example, using EV/EBITDA and EV/Sales allows us to see what investors are paying for the company's growth.
If a company is experiencing growth rates larger than the industry leaders, you can still use a multiples valuation. It's just more important to examine the individual drivers of growth and revenue.
Key Takeaways
The Multiples Valuation method is an objective approach to valuing a company.
It uses multiples of companies in the same sector to estimate a target stock price.
This method is easy to use since there is so much information about these companies on the internet.
The multiples valuation method involves estimating the current value of a company by applying a multiple to some measure of the company’s performance.
The EV/EBITDA, P/E, P/B, and P/S are the most common multiples that are used by investors.
You can read our other blogs here:
5 Benefits of Relative Valuation with Formula and Example
Discounted Cash Flow Valuation: What, How, and Methodology in 4 Easy Steps
Intrinsic Valuation: What, why, 3 Easy Methods, and Formula