Damodaran on Valuation

8.5. CONCLUSION

With equity multiples, we scale the market value of equity to some measure of equity earnings, book value, or even revenues. The most commonly used equity multiple is the price-earnings ratio, where the market value of equity is scaled to net income. Even that simple ratio is defined in different ways by different analysts, and we began this chapter by looking at the variations. We then considered variations on the P/E ratio as well as price-to-book equity and price-to-sales ratios; the latter is not a consistently defined multiple but still remains widely used.

Equity multiples are ultimately determined by the same fundamentals that determine the value of equity in a discounted cash flow model—expected growth in earnings, equity risk, and cash flow potential. Firms with higher growth, lower risk, and higher payout ratios, other things remaining equal, should trade at much higher multiples of earnings, book value of equity, and revenues than other firms. To the extent that there are differences in fundamentals across countries, across time, and across companies, the multiples will also vary. A failure to control for these differences in fundamentals can lead to erroneous conclusions based purely upon a direct comparison of multiples.

There are several ways in which equity multiples can be used in valuation. One way is to compare multiples across a narrowly defined group of comparable firms and to control for differences in growth, risk, and payout subjectively. ...