12.1 PRELIMINARY REMARKS
12.1.1 Multiples and Discounted Cash Flow
The multiples method enables us to define the equity and/or enterprise value of a company using negotiated prices of stocks of similar firms.
The multiples method seeks to develop a relationship between the actual price of shares of comparable listed companies and an accounting metric (such as net income, cash flows, revenues, etc.). This relationship, that is, the multiple, is then applied to the firm's internal metric in order to determine the value of the company through a simple multiplication.
A valuation performed with multiples is based on two assumptions:
- The company's value changes proportionally to the internal variables chosen as a measure of performance;
- The growth rates of both cash flows and the risk level are constant.
If both these hypotheses are verified, the multiples method gives a more “neutral” measure than the one based on the firm's cash flow (DCF), as it takes into account the market expectations on both the growth rate and the discount rate.
In reality, companies rarely satisfy these two hypotheses: cash flows might have different growth rates and the risk level could vary. Moreover, the best measure of performance to be used to compare different companies is not easily identifiable.
On the other hand, financial methods are usually based on expected cash flows, which relate directly to the company being evaluated, and on the discount rate derived from ...