What is the Multiples Approach
The multiples approach is a valuation theory based on the idea that similar assets sell at similar prices. This assumes that a ratio comparing value to some firm-specific variable (operating margins, cash flow, etc.) is the same across similar firms.
The multiples approach is also referred to as the “multiples analysis” or “valuation multiples.”
BREAKING DOWN Multiples Approach
Generally, “multiples” is a generic term for a class of many different indicators that can be used to value a stock. A multiple is simply a ratio that is calculated by dividing the market or estimated value of an asset by a specific item on the financial statements or other measure. The multiples approach is a comparables analysis method that seeks to value similar companies using the same financial metrics.
An analyst using this valuation approach assumes that a certain ratio is applicable and can be applied to various companies operating within the same line of business or industry. In other words, the idea behind the multiples analysis is that when firms are comparable, the multiples approach can be used to determine the value of one firm based on the value of another. The multiples approach seeks to capture many of a firm’s operating and financial characteristics (e.g., expected growth) in a single number that can be multiplied by some financial metric (e.g., EBITDA) to yield an enterprise or equity value.
Enterprise value multiples and equity multiples are the two categories of valuation multiples. Enterprise value multiples include the enterprise-value-to-sales ratio (EV/sales), EV/EBIT and EV/EBITDA. Equity multiples involve examining ratios between a company’s share price and an element of the underlying company’s performance, such as earnings, sales, book value or something similar. Common equity multiples include price-earnings (P/E) ratio, price-earnings to growth (PEG) ratio, price-to-book ratio and price-to-sales ratio.
Equity multiples can be artificially impacted by a change in capital structure, even when there is no change in enterprise value (EV). Since enterprise value multiples allow for direct comparison of different firms, regardless of capital structure, they are said to be better valuation models than equity multiples. Additionally, enterprise valuation multiples are typically less affected by accounting differences, since the denominator is computed higher up on the income statement. However, equity multiples are more commonly used by investors because they can be calculated easily and are readily available via most financial websites and newspapers.
In order to build a multiple, the companies that are similar to each other need 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.