Question

what are the main problems of applying valuation multiples in practice?

Answer 1

Combination of Various Factors: A multiple is a distillation of a great deal of information into a single number or series of numbers. By combining many value drivers into a point estimate, multiples may make it difficult to disaggregate the effect of different drivers, such as growth, on value. The danger is that this encourages simplistic and possibly erroneous interpretation.

Historic: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture the dynamic and ever-evolving nature of business and competition.

Difficulties in comparisons: Multiples are primarily used to make comparisons of relative value. But comparing multiples is an exacting art form, because there are so many reasons that multiples can differ, not all of which relate to true differences in value. For example, different accounting policies can result in diverging multiples for otherwise identical operating businesses.

Dependence on correctly valued peers: The use of multiples only reveals patterns in relative values, not absolute values such as those obtained from discounted cash flow valuations. If the peer group as a whole is incorrectly valued, then the resulting multiples will also be misvalued.

Short-term: Multiples are based on historic data or near-term forecasts. Valuations based on multiples will therefore fail to capture differences in projected performance over the longer term, and will have difficulty correctly valuing cyclical industries unless somewhat subjective normalization adjustments are made.