Damodaran on Valuation

7.5. FOUR BASIC STEPS TO USING MULTIPLES

Multiples are easy to use and easy to misuse. There are four basic steps to using multiples wisely and for detecting misuse in the hands of others. The first step is to ensure that the multiple is defined consistently and that it is measured uniformly across the firms being compared. The second step is to be aware of the cross-sectional distribution of the multiple, not only across firms in the sector being analyzed but also across the entire market. The third step is to analyze the multiple and understand not only what fundamentals determine the multiple but also how changes in these fundamentals translate into changes in the multiple. The final step is finding the right firms to use for comparison and controlling for differences that may persist across these firms.

7.5.1. Definitional Tests

Even the simplest multiples are defined differently by different analysts. Consider, for instance, the price-earnings (P/E) ratio, the most widely used multiple in valuation. Analysts define it to be the market price divided by the earnings per share, but that is where the consensus ends. There are a number of variants on the P/E ratio. While the current price is conventionally used in the numerator, some analysts use the average price over the last six months or a year. The earnings per share in the denominator can be the earnings per share from the most recent financial year (yielding the current P/E), the last four quarters of earnings (yielding ...