Multiples Approach

What Is the Multiples Approach?

The multiples approach is a valuation theory based on the idea that similar assets sell at similar prices. It assumes that the type of ratio used in comparing firms, such as operating margins or cash flows, is the same across similar firms.

Investors also refer to the multiples approach as multiples analysis or valuation multiples. When doing so they might refer to a financial ratio, such as the price-to-earnings (P/E) ratio, as the earnings multiple.

The Basics of the Multiples Approach

Generally, "multiples" is a generic term for a class of different indicators that can be used to value a stock. A multiple is simply a ratio that is calculated by partitioning the market or estimated value of an asset by a specific item on the financial statements. The multiples approach is a comparables analysis method that seeks to value similar companies using the same financial metrics.

An analyst using the valuation approach assumes that a particular ratio is applicable and applies to various companies operating inside the same line of business or industry. In other words, the idea behind 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 a considerable lot of a firm's operating and financial characteristics (e.g., expected growth) in a single number that can be multiplied by a specific financial metric (e.g., EBITDA) to yield an enterprise or equity value.

Common Ratios Used in the Multiples Approach

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-to-earnings (P/E) ratio, price-earnings to growth (PEG) ratio, price-to-book ratio (P/B), and price-to-sales (P/S) ratio.

Equity multiples can be misleadingly impacted by a change in capital structure, even when there is no change in enterprise value (EV). Since enterprise value multiples take into consideration direct comparison of different firms, regardless of capital structure, they are said to be better valuation models than equity multiples. Furthermore, 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 by means of most financial websites and newspapers.

Using the Multiples Approach

Investors start the multiples approach by identifying similar companies and evaluating their market values. 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 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.

Example of the Multiples Approach

Let's assume that an analyst wants to conduct the multiples approach to compare where major banking stocks trade in relation to their earnings. They can do this easily by creating a watchlist of the S&P 500's four largest banking stocks with each bank's P/E ratio, like in the example below:

An analyst can rapidly see that Citigroup Inc. (C) trades at a discount to the other three banks in relation to its earnings, having the lowest P/E ratio of the group at 15.4x. Wells Fargo, meanwhile, has a far larger P/E multiple nearing 100x, likely due to poor earnings that are expected to pivot. The P/E ratio mean, or average, of the four stocks is calculated by adding them together and separating the number by four.

(95.6 + 15.4 + 20.8 + 17.2)/4 = 37 average P/E ratio

The analyst currently knows that Bank of America Corporation (BAC), JP Morgan (JPM), and Citigroup all trade at a discount to the major bank P/E ratio mean using the multiples approach.

Highlights

• The multiples approach is a comparables analysis or relative valuation method that seeks to evaluate similar companies using the same standardized financial metrics.
• Commonly used equity multiples include P/E multiple, PEG, price-to-book, and price-to-sales.
• Enterprise value multiples and equity multiples are the two categories of valuation multiples.