Table of Contents
- What Is a Multiple?
- Key Takeaways
- How to Calculate Multiples: Formula and Examples
- Basics of Understanding Financial Multiples
- Different Types of Financial Multiples
- Practical Example: Understanding a Financial Multiple
- What Is the Multiples Approach?
- What Do Trading Multiples Tell You?
- What Does Price-to-Earnings Tell You?
- The Bottom Line
What Is a Multiple?
Let me explain what a multiple is—it's a key tool you can use to evaluate a company's valuation and financial health. You get it by dividing one financial metric by another, which lets you see if a company is underpriced or overpriced compared to others in its industry. If you understand types like price-to-earnings (P/E) and EV-to-EBITDA, you'll be better equipped to make comparisons and decide on investments.
Key Takeaways
Multiples serve as financial tools to assess valuation by dividing one performance metric by another. You'll often encounter types like price-to-earnings (P/E), enterprise value (EV) to EBITDA, and EV to sales. These help you compare market values and spot investment opportunities within the same industry. The P/E multiple is especially common for checking if a stock is overvalued or undervalued. Meanwhile, enterprise value-based multiples like EV/EBITDA give a fuller picture beyond just market capitalization.
How to Calculate Multiples: Formula and Examples
The formula for multiples is straightforward: Multiple = Performance Metric A / Performance Metric B. You divide the first metric by the second, and remember, the numerator is usually larger than the denominator.
Basics of Understanding Financial Multiples
Metrics are quantitative measures of a company's performance, used by executives for finance and operations, by analysts for recommendations, and by investors for portfolio decisions. When you combine them by dividing one by another, you create multiples that reveal aspects of financial health. Investors often use two methods for stock valuation: one based on cash flow, like discounted cash flow, which is intrinsic, and the other based on multiples, which is relative to performance measures like earnings or sales. The multiples approach assumes similar assets sell for similar prices.
Different Types of Financial Multiples
Let's start with the price-to-earnings (P/E) multiple—it's the most common for stock valuation, comparing market value to earnings. A high P/E means the stock is trading high relative to earnings, suggesting overvaluation, while a low P/E indicates undervaluation. For example, a P/E of 5x means the stock trades at five times earnings, and 10x means ten times.
Next, the EV/EBITDA multiple uses enterprise value (EV), which is market cap plus debt minus cash, to show what it would cost to buy the company. This multiple compares EV to EBITDA and is great for industry comparisons, often seen as a solid cash flow measure.
The EV/EBIT multiple is like P/E but uses EBIT, giving a complete picture of performance and worth, especially for firms with low depreciation.
Finally, the EV/sales multiple compares EV to annual sales, factoring in equity and debt, and it's useful for companies with negative earnings—always compare it within the same industry.
Practical Example: Understanding a Financial Multiple
A multiple shows what investors pay per dollar of earnings, like in the P/E ratio. Say you're looking at a stock with $2 EPS trading at $20—that gives a P/E of 10, meaning investors pay 10 times the current EPS.
What Is the Multiples Approach?
The multiples approach is a valuation theory where similar assets sell at similar prices, so financial ratios like EV/EBIT and EV/EBITDA should be comparable across similar firms.
What Do Trading Multiples Tell You?
Trading multiples are metrics that evaluate companies, highlighting their financial strength. Common ones include discounted cash flow, price-to-earnings, and enterprise value-to-revenue.
What Does Price-to-Earnings Tell You?
Price-to-earnings compares market value to earnings—a high P/E means overvaluation due to high market value relative to earnings, while a low P/E suggests undervaluation.
The Bottom Line
Multiples are essential for checking a company's financial health, growth, efficiency, and performance. You should use ones like P/E and EV/sales to gain insights into valuation and market position. Rely on a range of multiples for thorough analysis, not just one, to compare similar companies and make solid investment choices.
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