18Using Multiples

While discounted cash flow (DCF) is the most accurate and flexible method for valuing companies, using a relative valuation approach, such as juxtaposing the earnings multiples of comparable companies, can provide insights and help you summarize and test your valuation. In practice, however, multiples are often used in a superficial way that leads to erroneous conclusions. This chapter explains how to use multiples correctly. Most of the focus will be on earnings multiples, the most commonly used variety. At the end, we’ll also touch on some other multiples.

The basic idea behind using multiples for valuation is that similar assets should sell for similar prices, whether they are houses or shares of stock. In the case of a share of stock, the typical benchmark is some measure of earnings, most popularly the price-to-earnings (P/E) multiple, which is simply the equity value of the company divided by its net income. Multiples can be used to value nontraded companies or divisions of traded companies and to see how a listed company is valued relative to peers. Companies in the same industry and with similar performance should trade at the same multiple.

Valuing a company by using multiples may seem straightforward, but arriving at useful insights requires careful analysis. Exhibit 18.1 illustrates what happens if you don’t go deep enough in your multiples analysis. The managers of Company A, a producer of packaged foods, looked only at P/Es and were concerned ...

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