Question

When valuing companies we typically look at transaction multiples (what companies were actually sold for) or public market multiples. What are some potential pitfalls of using average multiples? Question 20 options: Companies may not be as similar as the multiples would suggest. Competitive position may vary widely. Margins and returns may vary widely. All of the above.

Answer 1

Answer of this question is ALL of the above.

There can be severral reasons for which the avarage multiple method is flawed.

Companies may not be similar as the multiple suggests. Suppose we are valuing a company and using P/E multiple and taking average of 4 companies in the same industry. This can be possible that companies which we are choosing for valuation are in the same industry but have completely different model all together. In that case, this is should not be a comparable and we have taken wrong multiple.

Similarly Competitive position may vary for each firm. Taking a relative new company P/E and mixing it up with a well established firm to value our company can also lead to errors. Scale, experience, maturity level etc everything is different in those 2 companies.

On the same line, a relatively new company will have less margins and higher cost as compared to others. On the other hand, experienced firm will have stable returns and earnings. Due to this earnings difference, the multiples get distorted and we will not get correct answer.