Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHOOSING A BETTER COMPARABLE

Multiples are simple to apply as a valuation tool, but valuations derived from multiples can be subjective. That is not to say that a DCF model will not produce a subjective valuation, but the key to a good multiple-based approach is a judicious selection of peers. So, Bhojraj and I (2002) used valuation theory, or a valuation-based approach, to select the subset of comparable companies used to determine the median multiple for valuation purposes. Our approach is to identify the driver(s) of each multiple and systematically find the companies with the best fit based on those drivers and use them as the peer group. The next step is to find a “warranted multiple” for each company and then match companies on the basis of how close their warranted multiples are to the warranted multiple of the target company. Through judicious selection of comparable companies, the simplicity of the multiples method can be retained, but much of its subjectivity can be removed.

Two Key Issues

When multiples are used for valuation, two key issues must be decided. First, what multiple should be used? In other words, which fundamental accounting variable should be selected? Recent research shows that expected earnings on a two- or three-year forward-looking basis provides the best explanatory power for price and that sales has the worst explanatory power.7 The median, or the harmonic mean, is the best measure for averaging multiples for many companies. The harmonic mean is ...