This article includes a list of references, but its sources remain unclear because relative profitability has insufficient inline citations. This process of standardizing creates valuation multiples. Multiples analysis is one of the oldest methods of analysis.
It was well understood in the 1800s and widely used by U. 20th century, although it has recently declined as Discounted Cash Flow and more direct market-based methods have become more popular. A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. Not all multiples are based on earnings or cash flow drivers.
In practice, no two businesses are alike, and analysts will often make adjustment to the observed multiples in order to attempt to harmonize the data into more comparable format. These adjustments can involve the use of regression analysis against different potential value drivers and are used to test correlations between the different value drivers. Simplistic: A multiple is a distillation of a great deal of information into a single number or series of numbers. By combining many value drivers into a point estimate, multiples may make it difficult to disaggregate the effect of different drivers, such as growth, on value. Static: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture the dynamic and ever-evolving nature of business and competition. Difficulties in comparisons: Multiples are primarily used to make comparisons of relative value.
But comparing multiples is an exacting art form, because there are so many reasons that multiples can differ, not all of which relate to true differences in value. For example, different accounting policies can result in diverging multiples for otherwise identical operating businesses. Dependence on correctly valued peers: The use of multiples only reveals patterns in relative values, not absolute values such as those obtained from discounted cash flow valuations. Short-term: Multiples are based on historic data or near-term forecasts. Valuations based on multiples will therefore fail to capture differences in projected performance over the longer term, and will have difficulty correctly valuing cyclical industries unless somewhat subjective normalization adjustments are made.
Despite these disadvantages, multiples have several advantages. Usefulness: Valuation is about judgment, and multiples provide a framework for making value judgements. When used properly, multiples are robust tools that can provide useful information about relative value. Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user-friendly method of assessing value. Multiples can help the user avoid the potentially misleading precision of other, more ‘precise’ approaches such as discounted cash flow valuation or EVA, which can create a false sense of comfort.
Relevance: Multiples focus on the key statistics that other investors use. Since investors in aggregate move markets, the most commonly used statistics and multiples will have the most impact. These factors, and the existence of wide-ranging comparables, help explain the enduring use of multiples by investors despite the rise of other methods. Equity price based multiples are most relevant where investors acquire minority positions in companies. Care should be used when comparing companies with very different capital structures.
Different debt levels will affect equity multiples because of the gearing effect of debt. In addition, equity multiples will not explicitly take into account balance sheet risk. Most widely used in valuing financial companies, such as banks, because banks have to report accurate book values of their loans and deposits, and liquidation value is equal to book value since deposits and loans are liquidated at same value as reported book values. The following diagram shows an overview of the process of company valuation using multiples. All activities in this model are explained in more detail in section 3: Using the multiples method.
Determine the year after which the company value is to be known. Their goal is to provide professionals with software for simulating virus outbreaks. Their only investor is required to wait for 5 years before making an exit. Important characteristics include: operating margin, company size, products, customer segmentation, growth rate, cash flow, number of employees, etc. E ratios substantially higher or lower than the peer group. Further market research shows that PM Software has recently acquired a government contract to supply the military with simulating software for the next three years. E ratio and only use the values of 17.
They calculate their discount factor based on five years. Calculate the current value of the future company value by multiplying the future business value with the discount factor. This is known as the time value of money. The Evolution of Valuation in Bankruptcy”. Valuation Multiples: A Primer UBS Warburg.