Valuation Multiples

The multiples approach is a valuation method based on the principle that similar assets sell at similar prices. This approach assumes that a ratio of market value to some firm-specific variable (operating margins, cash flow, etc.) is the same across similar firms. Valuation multiples attempt to capture many of a firm’s operating and financial characteristics in a single number that can be multiplied by some financial metric (e.g., EBITDA) to yield a total or enterprise value. Whereas in discounted cash flow (DCF) valuation, the objective is to find the value of future cash flow based on growth and risk characteristics, the objective of the multiple valuation is to value assets based upon how similar assets are currently priced in the market.

Methodology Rationale

The approach is based on the use of a multiple, which is simply a ratio between potential price (equity or enterprise value (EV)) and a company variable. According to this methodology, the valuation process is performed as follows: (i) choose the multiple on the basis of which to value the company (e.g., price-to-earnings); (ii) choose a sample of comparable companies (so-called ‘peers’) and calculate the value of the multiple at these companies; and (iii) take the value of the multiple at peers level (for example the average value) and use it to calculate the value (potential price) of the company. See Valuation > Market Approach > Comparable Sales.

Choice of Multiples

There are a large number of multiples that can be used in a valuation, including:

• Earnings of the asset
  • Net income: Price/Earnings Ratio (PE) and variants
  • Operating income and cash flow: EV/EBIT, EV/EBITDA
• Book value of the asset
  • Price/Book Value of Equity (PBV)
  • Enterprise Value/Invested Capital, Firm Value / Book Value of Capital
  • Enterprise Value/Replacement Cost
• Revenues generated by the asset
  • Price/Sales per Share (PS)
  • Enterprise Value/Sales
• Asset or Industry Specific Variable (e.g., EV/ton of reserves, EV/MW of generating capacity).

Reasonable multiples should meaningfully link market values to the relevant measure and show consistency across companies once differences in growth are accounted for. Also, it should be possible to explain their evolution over time.

Adjustments for Non-Recurring Items and Different Accounting Policy

Accounting policy differences can significantly affect multiples and, as a result, paint a misleading picture of relative valuation from one company to another. To treat comparables on a similar basis, adjustments must be made to account for unusual or non-recurring gains and losses, which are given a variety of names such as extraordinary, exceptional, or abnormal. For instance, it is necessary to adjust for non-recurring items related to lawsuits, arbitrations, insurance claim recoveries and one-time disputes. Such extraordinary income or expenses would be deducted (in the case of income such as an insurance claim recovery) or added back (in the case of an expense such as a lawsuit settlement). Similarly, adjustments for differences in accounting are usually necessary if the subject company and the comparable companies use different methods of accounting such that these different methods may result in distortions in comparability. For instance, companies may use different inventory methods (e.g., LIFO v. FIFO), rules for depreciation (e.g., accelerated v. straight-line), classification of leases (e.g., capital v. operating), etc.

Strengths

The market multiple approach is one of the most widely used valuation methods in day-to-day business operations. There are many reasons for its popularity. First, a valuation based on a multiple can be completed with far fewer assumptions and far more quickly than a discounted cash flow valuation. Second, a valuation based on market multiples is simpler to understand and easier to present than an income-based valuation (e.g., DCF or APV). Finally, a market multiple approach may more closely reflect the current mood of the market, since it is an attempt to measure relative and not intrinsic value. For instance, in a market where all blue chip stocks see their prices bid up, relative valuation is likely to yield higher values for these stocks than discounted cash flow valuations. Thus, valuations based on market multiples may yield values that are closer to the actual traded market price than DCF valuations.

Weaknesses

While multiples are easy to use and intuitive, they are also easy to misuse and imprecise. Three issues may arise. First, to value assets on a multiple basis, prices have to be standardized, usually by converting prices into multiples of earnings, book values or sales, but those measures may reflect differences in accounting treatment or distort the link between value and the cash flows from which it ultimately arises. Second, it can be difficult to find similar companies, since no two businesses are exactly identical and companies in the same business sector can differ on risk, growth potential, cash flows outlook, business model, product mix, risk, geographical coverage, growth opportunities, ownership structure, etc. Third, multiples represent a snapshot of where a company is at a point in time, but fail to capture the dynamic and ever-evolving nature of business and competition. See Valuation > Market Approach > Comparable Sales.

For these reasons, multiples can most often be considered more of a rough-and-ready valuation approach that may lack the rigor of income approaches. For that reason, multiples can be most helpful in verifying valuations based on income approaches or serving as a primary method where income valuations are not reliable (for example, due to lack of relevant forecasts).