The Multiples Approach: Valuing Similar Assets Effectively
The multiples approach is a valuation method based on the idea that similar assets should have similar prices. By assuming that specific financial ratios, such as operating margins or cash flow, are consistent among similar firms, this approach provides a comparative analysis for asset valuation.
Investors often refer to the multiples approach as multiples analysis or valuation multiples. Commonly, financial ratios like the price-to-earnings (P/E) ratio are used, also known as the earnings multiple.
Key Takeaways
- The multiples approach enables comparative analysis or relative valuation of similar companies using consistent financial metrics.
- There are two major categories of valuation multiples: enterprise value multiples and equity multiples.
- Commonly used equity multiples include P/E multiple, PEG, price-to-book, and price-to-sales.
Basics of the Multiples Approach: Streamlining Stock Valuation
“Multiples” is essentially a comprehensive term for various indicators that can be used to value a stock. A multiple is calculated by dividing the market or estimated value of an asset by a specific item on the financial statements. This approach aims to value similar companies using the same financial metrics.
An analyst applying this valuation method assumes that a particular ratio is relevant across companies operating in the same industry. The multiples approach captures a firm’s operating and financial characteristics, such as expected growth, in one number that can be multiplied by a financial metric (like EBITDA) to derive enterprise or equity value.
Common Ratios Used in the Multiples Approach
Both enterprise value multiples and equity multiples are employed in this valuation approach. Enterprise value multiples include the enterprise-to-sales (EV/sales) ratio, EV/EBIT, and EV/EBITDA. Equity multiples compare a company’s share price with elements of the company’s performance such as earnings, sales, and book value. Common equity multiples are the price-to-earnings (P/E), price-to-earnings to growth (PEG), price-to-book (P/B), and price-to-sales (P/S) ratios.
Equity multiples can be deceptively impacted by changes in capital structure, even when enterprise value remains unchanged. As such, enterprise value multiples are generally seen as better valuation models. They allow for direct comparison across different firms, regardless of capital structure, and are less influenced by accounting differences. Nevertheless, equity multiples are more frequently used by investors because they are easy to calculate and commonly accessible.
Applying the Multiples Approach: A Practical Guide
To use the multiples approach, investors start by identifying similar companies and evaluating their market values. The next step involves calculating a multiple for these comparable firms and aggregating these into a standardized figure, such as the mean or median. This key multiple is then applied to the firm under analysis to estimate its value.
When building a multiple, it is advisable to use a forecast of future profits, aligning with the principle that a company’s value is the present value of its future cash flows rather than past profits.
Example: Evaluating Major Banking Stocks Using the Multiples Approach
Assume an analyst wants to compare major banking stocks using their P/E ratios. By identifying the S&P 500’s largest banking stocks and their P/E ratios, as shown below, they can perform a quick analysis:
Trailing 12-mo. P/E for Top 4 Banks (as of April 1, 2021) | |
---|---|
Bank | Trailing P/E |
Wells Fargo | 95.6 |
Citigroup | 15.4 |
Bank of America | 20.8 |
JP Morgan Chase | 17.2 |
An analyst would immediately notice that Citigroup’s P/E ratio of 15.4x trades at a discount compared to the other three banks. Meanwhile, Wells Fargo’s high P/E ratio of nearly 100x could indicate poor but expectedly improving earnings. The average P/E ratio of these four stocks is:
(95.6 + 15.4 + 20.8 + 17.2) / 4 = 37
This implies that Bank of America, JP Morgan, and Citigroup all trade below the average P/E ratio, offering valuable insights using the multiples approach.
Related Terms: financial ratios, equity value, enterprise value, valuation multiples, operating margins, EBITDA