What is a Valuation Multiple Analysis?
A valuation multiple analysis is used to estimate the value of a business. The valuation analysis compares businesses to each other based on a multiple of a relevant financial metric such as sales, earnings, or book value.
Using a valuation multiple analysis is not only one of the simplest ways to assess business value, but it is also one of the most helpful because of its ease of use and flexibility.
An analyst can compare two businesses on the most relevant metric (which varies by industry) and quickly determine if one business appears to be valued more richly than another.
This can serve as critical data point in the investment decision process.
Understanding the Valuation Multiple Analysis Approach
The theory behind the valuation multiple analysis is that two identical or very similar companies should be valued similarly.
In reality, no two companies are exactly the same. Differences in profit margins, growth rates, management teams, and many other factors can result in two similar companies being valued very differently.
In a valuation multiple analysis, the numerator is usually the price of a stock or the total value of a company (market capitalization or enterprise value) and the denominator is the financial metric being compared.
For example, a price-to-earnings (P/E) ratio divides a company’s stock price by its earnings per share. Keeping the level of earnings constant, a higher stock price would result in a higher price-to-earnings ratio, making a company relatively more richly valued.
On the other hand, if a stock has a statistically low price-to-earnings ratio compared to other similar companies, it may be considered “cheap” or inexpensive to buy.
Take two companies that operate in the same industry.
If Company A has a price-to-earnings ratio of 15 and Company B has a price-to-earnings ratio of 10, then Company B trades for a relatively cheaper valuation according to a price-to-earnings multiple analysis.
In this case, Company B may be the better stock to buy. The image below illustrates this scenario.
Valuation Analysis Limitations
However, there are many nuances to this type of analysis.
Company B may be “cheap for a reason” because it is poorly managed or is losing market share.
Alternatively, the price-to-earnings ratio may be skewed by a difference in accounting policies at the two companies. This artificially inflates Company B’s earnings and thus makes it appear cheaper than it actually is.
It is also possible that Company B is cheaper on one metric, such as price-to-earnings, but at the same time is more expensive on a separate metric, such as price-to-cash flow.
This is all to say that, when conducting a valuation multiple analysis, you should be careful to understand why a discrepancy in valuation multiples might exist.
If there is no good reason for one company to trade cheaper than another company, then there may be a good buying opportunity.
One best practice is to compare companies across multiple dimensions rather than just one simple valuation metric.
For example, in addition to comparing the price-to-earnings ratio of two companies, an analyst can also compare their growth rates, profit margins, and price-to-cash flow multiples, to provide a more comprehensive comparison.