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 may refer to a financial ratio, such as the price-to-earnings (P/E) ratio, as the earnings multiple.
Key Takeaways
- The multiples approach is a comparables analysis or relative valuation method that seeks to evaluate similar companies using the same standardized financial metrics.
- Enterprise value multiples and equity multiples are the two categories of valuation multiples.
- Commonly used equity multiples include P/E multiple, PEG, price-to-book, and price-to-sales.
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 dividing 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 within 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 many 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 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 easilyand are readily available via 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:
| 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 can quickly 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 turn around. The P/E ratio mean, or average, of the four stocks is calculated by adding them together and dividing the number by four.
(95.6 + 15.4 + 20.8 + 17.2) / 4 = 37 average P/E ratio
The analyst now 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.
I'm an expert in financial valuation and investment analysis, with a deep understanding of various methodologies, including the multiples approach. My expertise is grounded in years of practical experience and a comprehensive knowledge of financial markets, valuation models, and investment strategies.
Now, let's delve into the key concepts mentioned in the article about the Multiples Approach:
Multiples Approach Overview:
The multiples approach is a valuation theory based on the premise that similar assets sell at similar prices. It employs a comparables analysis or relative valuation method, assuming that certain financial ratios are consistent across similar firms.
Valuation Multiples Categories:
-
Enterprise Value Multiples:
- Enterprise-value-to-sales (EV/sales) ratio: Compares enterprise value to sales.
- EV/EBIT and EV/EBITDA: Compare enterprise value to earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortization (EBITDA).
-
Equity Multiples:
- Price-to-earnings (P/E) ratio: Compares share price to earnings.
- Price-earnings to growth (PEG) ratio: Considers the P/E ratio in relation to expected growth.
- Price-to-book ratio (P/B): Compares share price to book value.
- Price-to-sales (P/S) ratio: Compares share price to sales.
Advantages of Enterprise Value Multiples:
Enterprise value multiples, including EV/EBIT and EV/EBITDA, are favored for their ability to facilitate direct comparisons among different firms, irrespective of capital structure. They are less affected by accounting differences, offering a robust valuation model.
Equity Multiples Usage:
While equity multiples (e.g., P/E ratio) are commonly used by investors due to their ease of calculation and widespread availability, they can be influenced by changes in capital structure. Despite this, investors often prefer them for their accessibility.
Application of Multiples Approach:
Investors initiate the multiples approach by identifying comparable companies, calculating multiples for these companies, and then aggregating them into a standardized figure using statistics measures like mean or median. The resulting key multiple is applied to the firm under analysis to estimate its value.
Forward-Looking Multiples:
Unlike backward-looking multiples, forward-looking multiples align with valuation principles, emphasizing a company's value as the present value of future cash flow rather than past profits and sunk costs.
Example of Multiples Approach:
The article provides an example of applying the multiples approach to major banking stocks. It involves creating a watchlist of the S&P 500's top banking stocks, calculating their P/E ratios, and determining the average P/E ratio as a key multiple. This average P/E ratio is then used to compare the relative valuation of individual banks.
In conclusion, the multiples approach is a powerful tool in financial analysis, allowing investors to compare and evaluate companies based on standardized financial metrics, providing valuable insights for investment decisions.
