Valuation Using Multiples
Valuation using multiples often known as relative valuation is a technique that is used for making an estimate of the value of an asset and this is done by making a comparison of the asset’s value with the values of similar assets or comparables after analyzing the market.
Process of valuation using multiples
The process of valuation using multiples involves certain steps and they are:
1. Identify comparable or similar assets and gather market values for these comparable assets.
2. The market values of these assets are to be converted into standardized values which are relative to a key statistic as it is not possible to compare absolute prices. Valuation multiples are created by this process of standardization.
3. The valuation multiple is to be applied to the asset’s key statistics to control any difference between the asset being value and the comparable assets that may affect the multiple.
A valuation multiple is a term that is used to express the market value of an asset in comparison to a key statistic which is considered to be related to the market value. The key statistic can be cash flow, earnings or any other measure which must be logically related to the observed market value for being useful.
One of the commonly used multiples in stock trading is the P/E ratio or the price earnings ratio. This is popular because it is widely available and because of the importance attributed to earnings per share as value driver. The earnings per share can be distorted due to the differences in capital structures and accounting rules between companies and because of this, the effectiveness of P/E ratio is reduced.
All multiples are not based on cash flow drivers or earnings. The P/B ratio or price to book ratio is a multiple which compare the accounting book value of assets of a firm to the market value. The EV/sales ratio and price/sales ratio determines the value in relation to sales. These multiples involving book value and sales are unlikely value drivers than earnings and so they should be used cautiously. Valuation multiples are rarely based on industry-specific non-financial value drivers.