Valuation using multiples is a widely used method in finance to determine the value of a company by comparing it to similar companies in the market. This approach, also known as "relative valuation," involves analyzing various financial ratios or multiples to assess the relative worth of a company. In this comprehensive guide, we will explore the concept of valuation multiples, their types, how to use them, and their advantages and disadvantages.
Understanding Valuation Multiples
Valuation multiples are ratios that compare the market value of a company to a specific financial metric. These multiples provide a standardized way to compare the value of different companies and are commonly used in the valuation process. The key idea behind valuation multiples is that similar companies should have similar valuations based on comparable financial metrics.
There are two main categories of valuation multiples: enterprise value multiples and equity value multiples. Enterprise value multiples consider the total value of a company, including both equity and debt, while equity value multiples focus solely on the equity portion of a company's value.
Commonly used enterprise value multiples include EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization), EV/EBIT (enterprise value to earnings before interest and taxes), and EV/Sales (enterprise value to sales). Equity value multiples, on the other hand, include P/E (price-to-earnings) ratio, P/B (price-to-book) ratio, and P/S (price-to-sales) ratio.
How to Use Valuation Multiples
To use valuation multiples, analysts start by identifying comparable companies or assets, often referred to as the peer group. They then gather market values for these comparable assets and convert them into standardized values relative to a key statistic. This standardization process creates valuation multiples that can be applied to the company being valued.
There are two main approaches to using valuation multiples: comparable company analysis (CCA) and comparable transaction analysis (CTA). Comparable company analysis involves comparing a company to its peers based on valuation multiples derived from publicly available financial reports. On the other hand, comparable transaction analysis involves comparing a company to similar companies that have been acquired in mergers or acquisitions.
Analysts must carefully select the appropriate valuation multiples based on the nature of the business or industry being analyzed. This selection often involves referencing equity research reports of comparable companies to determine the multiples commonly used by industry analysts.
Advantages and Disadvantages of Valuation Multiples
Valuation multiples offer several advantages. They provide a quick and straightforward way to estimate a company's value, making them useful for initial assessments. Their simplicity and ease of calculation also make them user-friendly and accessible to a wide range of users. Additionally, valuation multiples focus on key statistics that other investors commonly use, making them relevant and influential in the market.
However, valuation multiples also have certain disadvantages. They can be overly simplistic, distilling complex information into a single number or series of numbers. This simplicity may make it challenging to isolate the effects of different value drivers, such as growth, on the overall value. Valuation multiples also provide a snapshot of a company's value at a specific point in time and may not capture the dynamic and evolving nature of business and competition.
Comparing multiples can be difficult, as there are numerous reasons why multiples can differ, including differences in accounting policies or capital structure. Valuation multiples are also based on historical or near-term forecasts, which may not fully capture projected performance over the long term.
Valuation Multiples in Practice
In practice, valuation multiples are used in various ways depending on the specific valuation context. For example, EV/EBITDA is commonly used as a valuation metric, as EBITDA is often considered a proxy for cash flow available to the firm. EV/EBITDA multiples typically range from 6.0x to 18.0x.
When analyzing companies with negative EBITDA, EV/Sales may be more appropriate, as it measures the enterprise value relative to revenue per share. This multiple is commonly used in the valuation of companies with operating costs that exceed revenues, such as nascent Internet firms.
P/E ratio is another widely used valuation multiple that compares a company's stock price to its earnings per share. P/E multiples typically range from 15.0x to 30.0x. The P/E/G ratio, which divides the P/E ratio by the expected EPS growth rate, is often used for high-growth companies and allows for comparisons between companies in different stages of their life cycles.
Calculating Valuation Multiples
Calculating valuation multiples involves determining the appropriate denominator, which represents the financial metric used in the multiple calculation. Denominators can be stock-based or flow-based, with flow-based denominators being measured over a period of time.
Historical valuation multiples are typically calculated over the last twelve months (LTM) period. For example, LTM EBITDA can be derived by adding the most recent stub period EBITDA to the full-year EBITDA and subtracting the corresponding stub period EBITDA from the previous year. Forward estimates provided by equity research analysts are often used for projected earnings and cash flows.
Adjustments may be necessary to exclude extraordinary or non-recurring items from the denominator, such as restructuring charges or one-time gains/losses. It is also essential to exclude the portion of the denominator attributable to non-controlling interests if excluded from the enterprise value calculation.
Conclusion
Valuation using multiples is a widely used method in finance for determining the value of a company. By comparing a company's financial metrics to those of similar companies, valuation multiples provide a standardized and accessible way to assess relative value. While valuation multiples have advantages such as simplicity and relevance, they also have limitations and must be used in conjunction with other valuation methods for a comprehensive analysis. Understanding the different types of valuation multiples and their applications is crucial for conducting accurate and informed valuations.
