Question

Explain briefly the limitations of an approach based on the use of multiples to value a firm.

Answer 1

Not all valuation methods are created equal.

Approach to maximizing shareholder value gravitate toward discounted-cash-flow (DCF) analyses as the most accurate and flexible method for value of a firm.

Any analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating the key ingredients of corporate value—ingredients such as a company’s return on invested capital (ROIC), its growth rate, and its weighted average cost of capital—can lead to mistakes in valuation and, ultimately, to strategic errors.

It is thought off that careful analysis comparing a company’s multiples with those of other companies can be useful in making such forecasts, and the DCF valuations they inform, more accurate.

Multiples are often misunderstood and, even more often, misapplied. Many analysis, for example, calculate an industry-average price-to-earnings ratio and multiply it by a company’s earnings to establish a “fair” valuation.

The use of the industry average, however, overlooks the fact that companies, even in the same industry, can have drastically different expected growth rates, returns on invested capital, and capital structures.

Even when companies with identical prospects are compared, the P/E ratio itself is subject to problems, since net income commingles operating and nonoperating items.

Limitiations of Multiples approach can be briefly summarized as below.

1) Simplifies complex information into just a single value or a series of values. This effectively disregards other factors that affect a company’s intrinsic value such as growth or decline. However, this helps to make quick computations to assess a company’s value.

2) Multiples analysis can also lead to difficulty in comparing companies or assets. This is because companies, even when they seem to have identical business operations, may have different accounting policies. As such, multiples may be easily misinterpreted and comparisons are not as conclusive. They need to be adjusted for different accounting policies.

3) Multiples analysis also disregards the future point in time – it is static. It only considers the company’s position for a certain time period and fails to include the company’s growth in its business operations. However, there are certain multiples that look at “leading” ratios.

Approach based on multiples to value a firm may not cause material valuation distortions in noncapital-intensive industries, or where all the facts about the comparables are known or reasonably allowed for, or if the valuation result is cross-checked to other methods. However, its use fails to allow for many value relevant differences in capital-intensive industries. It can also incorrectly treats pass-through capital cost reimbursement for periodic depreciation charges as part of free cash flows to equity. This method of valuation should not be used in isolation unless all material relevant facts about the entity being valued and the ‘comparable’ companies are known or reasonably allowed for. In many cases, they are not.