What Is a Multiple?
A multiple measures some aspect of a company's financial well-being, determined by dividing one metric by another metric. Metrics are quantitative tools that measure a company's performance. The metric in the numerator is typically larger than the one in the denominator. Investors use multiples to quantify a company's growth, productivity, and efficiency. They use multiples to make comparisons among companies and find the best investment opportunities.
For example, a multiple can be used to show how much investors are willing to pay per dollar of earnings, as computed by the price-to-earnings (P/E) ratio. Assume you are analyzing a stock with $2 of earnings per share (EPS), which is trading at $20. This stock has a P/E of 10. This means investors are willing to pay a multiple of 10 times the current EPS for the stock.
This is calculated as:
- A multiple measures the well-being of a company by comparing two metrics, usually by dividing one by the other.
- Investors generally rely on two stock valuation methods: one based on cash flow and the other based on a multiple of a performance measure.
- The most common multiple used in the valuation of stocks is the price-to-earnings (P/E) multiple.
- Enterprise value (EV) is a popular performance metric used to calculate different types of multiples, such as the EV to earnings before interest and taxes (EBIT) multiple and the EV to sales multiple.
In the world of stock valuation, investors and analysts generally rely on two major methods. One is based on cash flow, while the other is based on a multiple of some performance measure, such as earnings or sales. Valuation based on cash flow (i.e., the discounted cash flow analysis) is considered to be an intrinsic valuation. Valuation based on a multiple is considered to be relative because the multiple is relative to some performance measure. The multiples approach to valuation is a theory based on the concept that similar assets should sell for similar prices.
Price-to-Earnings (P/E) Multiple
The most common multiple used in the valuation of stocks is the P/E multiple. It is used to compare a company's market value (price) with its earnings. A company with a price or market value that is high compared to its level of earnings has a high P/E multiple. A company with a low price compared to its level of earnings has a low P/E multiple.
A P/E of 5x means a company’s stock is trading at a multiple of five times its earnings. A P/E of 10x means a company is trading at a multiple that is equal to 10 times earnings. A company with a high P/E is considered to be overvalued. Likewise, a company with a low P/E is considered to be undervalued.
Enterprise value (EV) is a popular performance metric used to calculate different types of multiples. EV shows how much money would be needed to buy a specific company. The EV of a company is calculated by taking the company's market capitalization, adding total debt (including long-term and short-term debt), and subtracting all cash and cash equivalents. Many investors see EV as a better performance metric than relying on market capitalization alone because it offers a more complete picture of a company's valuation.
A widely used multiple is the EV to earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple, also referred to as EV/EBITDA. This multiple helps investors compare companies in the same industry or sector before making an investment decision.
Many equity analysts consider EV/EBITDA to be a solid measure of cash flow available to a firm.
The EV to earnings before interest and taxes (EBIT) multiple, also referred to as EV/EBIT, is similar to the P/E multiple, but is preferred by some analysts for its ability to give a more complete picture of a company's financial performance and actual worth. The multiple is useful for pinpointing companies that might be undervalued or overvalued. It's best used for less capital-intensive companies, with fewer depreciation and amortization expenses.
The EV to sales ratio, also referred to as EV/sales, compares the enterprise value of a company to its annual sales. The EV/sales multiple is considered an important valuation tool because it takes into account a company's equity and debt while giving investors a quantifiable metric of how to value a company based on sales. It's also useful in evaluating companies with negative earnings. To be most effective, investors should compare the EV/sales multiple of the company they are analyzing to that of other companies in the same industry.