What Is the Multiples Approach?

What Is the Multiples Approach?

Let me explain the multiples approach directly: it's a valuation theory grounded in the principle that similar assets sell at similar prices. I assume that the ratios we use to compare firms, such as operating margins or cash flows, remain consistent across those similar firms.

You might hear investors call this multiples analysis or valuation multiples. For instance, when they talk about a financial ratio like the price-to-earnings (P/E) ratio, they often refer to it as the earnings multiple.

Understanding the Multiples Approach

In general, 'multiples' refers to a class of indicators you can use to value a stock. A multiple is straightforward—it's a ratio calculated by dividing the market or estimated value of an asset by a specific item from the financial statements. This approach is essentially a comparables analysis method that aims to value similar companies using the same financial metrics.

As an analyst, I assume that a particular ratio applies across various companies in the same industry or line of business. The core idea is that when firms are comparable, you can determine the value of one based on another's value using this multiples method.

What the multiples approach does is capture many of a firm's operating and financial characteristics—like expected growth—in a single number. You then multiply that by a specific financial metric, such as EBITDA, to get an enterprise or equity value.

Common Ratios Used in the Multiples Approach

You'll find two main categories here: enterprise value multiples and equity multiples. Enterprise value multiples include ratios like enterprise-value-to-sales (EV/sales), EV/EBIT, and EV/EBITDA.

Equity multiples look at ratios between a company's share price and aspects of its performance, such as earnings, sales, or book value. Common ones are the price-to-earnings (P/E) ratio, price/earnings-to-growth (PEG) ratio, price-to-book (P/B), and price-to-sales (P/S).

Keep in mind that equity multiples can be distorted by changes in capital structure, even if the enterprise value stays the same. That's why enterprise value multiples are often seen as better for direct comparisons across firms, ignoring capital structure differences. They're also less affected by accounting variations since they're based higher up on the income statement. Still, equity multiples are popular because they're easy to calculate and widely available on financial sites and in newspapers.

Using the Multiples Approach

To use this, you start by identifying similar companies and checking their market values. Then, compute multiples for those comparables and standardize them using something like the mean or median.

Apply that key multiple to the corresponding metric of the firm you're analyzing to estimate its value. Importantly, when building the multiple, use forecasts of profits in the denominator, not historical ones. Forward-looking multiples align better with valuation principles, focusing on the present value of future cash flows rather than past profits or sunk costs.

Example of the Multiples Approach

Suppose you want to compare major banking stocks based on their earnings. You could look at the S&P 500's four largest banks and their trailing 12-month P/E ratios. For instance, Wells Fargo at 13.10, Citigroup at 11.55, Bank of America at 13.17, and JP Morgan Chase at 12.79.

Here, Citigroup has the lowest P/E, which might indicate lower investor expectations or higher perceived risk. Bank of America has the highest, suggesting stronger growth prospects or confidence. Notice how they're all in a similar range, as you'd expect for comparable companies in the same industry.

Limitations of the Multiples Approach

One big limitation is how market sentiment and timing play in. Multiples come from market prices, which can be swayed by short-term factors like speculation or economic shifts, so valuations might reflect distortions rather than true fundamentals.

Finding truly comparable companies is tough too. Even in the same industry, differences in growth potential, capital structure, or margins can make comparisons invalid. You can't accurately compare a startup to a mature firm, for example.

This approach often skips company-specific elements like management quality, brand strength, or operational efficiency—these don't appear in ratios but matter a lot. It's a simplified method, which can sometimes mean it's oversimplified.

Finally, accounting differences and data inconsistencies can undermine it. Variations in practices like revenue recognition or depreciation skew metrics, and even with GAAP, reporting differences complicate things.

What Are the Advantages and Disadvantages of the Multiples Approach?

The advantage is its simplicity and speed—you can gain insights without deep calculations or extensive research. The disadvantage is that it reduces complex financial information to a single number, ignoring nuances.

What Are Important Financial Ratios to Evaluate a Company?

Key ratios include price-to-earnings (P/E), debt-to-equity (D/E), price-to-book (P/B), return on equity, return on invested capital, and profit margin.

What Is EV/EBITDA?

EV/EBITDA is a ratio comparing a company's enterprise value to its earnings before interest, taxes, depreciation, and amortization. Enterprise value represents the company's economic value, and this ratio measures return on investment.

The Bottom Line

As an analyst or investor, you need tools to compare companies for recommendations, analysis, and decisions. The multiples approach provides a straightforward way to analyze and compare firms against each other and their industry.