Price multiples (or price relatives) are often used by investors and analysts to get a first impression of where a stock should be trading. Price multiples are typically based on the method of comparables or forecasted fundamentals, or may evolve from a statistical analysis of drivers or common factors that are likely to impact the price of a company's stock. With knowledge of a benchmark multiple of, say, revenue, earnings, cash flow, or book value, a company's stock price can be estimated by multiplying the appropriate price multiple by the relevant company fundamental (expressed per share). For example, if the selected earnings measure was EBITDA per share (earnings before interest, taxes, depreciation, and amortization), then a company's stock price could be estimated as
The estimated stock price would then be compared to the actual price to see if the stock is either potentially undervalued (actual price or multiple is lower than estimated price or multiple) or overvalued (actual price or multiple is higher than estimated price or multiple). This type of equity valuation analysis, albeit simplistic, presumes that a company's stock price or actual multiple will return to an intrinsic value or target price multiple.
Stock Analysis Using Price Multiples
To illustrate the multiples approach to equity valuation, Exhibit 2.3 shows a graph of the price-to-earnings ...