Valuation using multiples

Process in Economics

In economics, valuation using multiples, or "relative valuation", is a process that consists of:
identifying comparable assets (the peer group) and obtaining market values for these assets. converting these market values into standardized values relative to a key statistic, since the absolute prices cannot be compared. This process of standardizing creates valuation multiples. applying the valuation multiple to the key statistic of the asset being valued, controlling for any differences between asset and the peer group that might affect the multiple. Multiples analysis is one of the oldest methods of analysis. It was well understood in the 1800s and widely used by U. S. courts during the 20th century, although it has recently declined as Discounted Cash Flow and more direct market based methods have become more popular. "Comparable company analysis", closely related, was introduced by economists at Harvard Business School in the 1930s.

A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – whether earnings, cash flow or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value. Other commonly used multiples are based on the enterprise value of a company, such as (EV/EBITDA, EV/EBIT, EV/NOPAT). These multiples reveal the rating of a business independently of its capital structure, and are of particular interest in mergers, acquisitions and transactions on private companies. Not all multiples are based on earnings or cash flow drivers. The price to book ratio (P/B) is a commonly used benchmark comparing market value to the accounting book value of the firm's assets. The price/sales ratio and EV/sales ratios measure value relative to sales. These multiples must be used with caution as both sales and book values are less likely to be value drivers than earnings. Less commonly, valuation multiples may be based on non financial industry specific value drivers, such as enterprise value / number of subscribers for cable or telecoms businesses or enterprise value / audience numbers for a broadcasting company. In real estate valuations, the sales comparison approach often makes use of valuation multiples based on the surface areas of the properties being valued.

Despite these disadvantages, multiples have several advantages. Usefulness: Valuation is about judgment, and multiples provide a framework for making value judgements. When used properly, multiples are robust tools that can provide useful information about relative value. Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user friendly method of assessing value. Multiples can help the user avoid the potentially misleading precision of other, more 'precise' approaches such as discounted cash flow valuation or EVA, which can create a false sense of comfort. Relevance: Multiples focus on the key statistics that other investors use. Since investors in aggregate move markets, the most commonly used statistics and multiples will have the most impact. These factors, and the existence of wide ranging comparables, help explain the enduring use of multiples by investors despite the rise of other methods.

The following diagram shows an overview of the process of company valuation using multiples. All activities in this model are explained in more detail in section 3: Using the multiples method.