In: Accounting
List and define common market multiples used to value a stock/company. Explain whether each values the company as a whole or the stock. Why might we use one particular multiple instead of another? What is the most difficult part of implementing a market multiple valuation method? Explain the issues that you need to consider when valuing a company using market multiples. Perform simple valuation calculations using multiples.
There are two main types of valuation multiples:
#1 Equity multiples
Investment decisions make use of equity multiples especially when an investor aspires for minority positions in companies. The list below shows some common equity multiples used in valuation analyses.
P/E Ratio – the most commonly used equity multiple; needed data is easily accessible; computed as the proportion of Share Price to Earnings Per Share (EPS)
Price/Book Ratio – useful if assets primarily drive earnings; computed as the proportion of Share Price to Book Value Per Share
Dividend Yield – used for comparisons between cash returns and investment types; computed as the proportion of Dividend Per Share to Share Price
Price/Sales – used for firms that make losses; used for quick estimates; computed as the proportion of Share Price to Sales (Revenue) Per Share
However, a financial analyst must take into account that companies have varying levels of debt that ultimately influence equity multiples.
#2 Enterprise Value (EV) multiples?
When decisions are about mergers and acquisitions, enterprise value multiples are the appropriate multiples to use. The list below shows some common enterprise value multiples used in valuation analyses.
EV/Revenue – slightly affected by differences in accounting; computed as the proportion of Enterprise Value to Sales or Revenue.
EV/EBITDAR – most used in industries in the hotel and transport sectors; computed as the proportion of Enterprise Value to Earnings before Interest, Tax, Depreciation & Amortization, and Rental Costs
EV/EBITDA – EBITDA can be used as a substitute of free cash flows; most used enterprise value multiple; computed as the proportion of Enterprise Value to Enterprise value / Earnings before Interest, Tax, Depreciation & Amortization
EV/Invested Capital – used for capital-intensive industries; computed as the proportion of Enterprise Value to Invested Capital
There are more equity and enterprise value multiples used in company valuation, this article only presented the most common ones. More readings and a thorough understanding of each multiple and related concepts can help analysts better apply multiples in making financial analyses.
Each values the company as a whole.
In order to build a multiple, the companies that are similar to each other have to be identified first, and each of their market values evaluated. A multiple is then computed for the comparable companies, and aggregated into a standardized figure using a key statistics measure such as the mean or median. The value identified as the key multiple among the various companies is applied to the corresponding value of the firm under analysis in order to estimate its value. When building a multiple, the denominator should use a forecast of profits, rather than historical profits. Unlike backward-looking multiples, forward-looking multiples are consistent with the principles of valuation—in particular, that a company’s value equals the present value of future cash flow, not past profits and sunk costs.