Multiples Approach Definition & Overview

KEY TAKEAWAYS

• The multiples approach is a type of valuation analysis that compares companies. The method evaluates similar companies that use the same financial metrics. 
• The two categories of valuation multiples are equity multiples and enterprise value multiples. 
• There can be several ratios used in the multiples approach. These can include price-to-sales, P/E multiple, and price-to-book.

What Is the Multiples Approach? 

Investing requires a lot of financial knowledge and understanding of certain valuation processes. The multiples approach is a specific type of valuation theory. It’s based on the simple concept that if companies have similar assets, they will sell at similar prices. It takes into consideration that financial definitions such as cash flows and operating margins are the same across the board. 

Knowing how these ratios work helps ensure that a potential investment is viable. Not only that, but it’s a great way to compare companies and invest in companies that are mostly likely to produce higher return on investment (ROI).

When considering the multiples approach, it means that you take several indicators into account to value a stock. 

Simply put, the multiples approach is a type of analysis method that compares companies’ financial metrics. When an analyst uses the approach, they would be comparing the metrics with other companies from the same industry. 

Basically, you can use the multiples approach to find the value of one business based on the value of another one. You’re able to dive deep into operating and financial characteristics and compare them together. For example, you can use this data and information to help forecast expected growth. 

What Are the Common Ratios Used in the Multiples Approach? 

There are two categories of valuation multiples that most ratios can fall into. They are the equity multiples and enterprise value multiples. 

Equity multiples are useful for investors who have minority positions in companies, and the ratios used in comparison are mostly leading to valuations of equity. Here are some of the most common equity multiples that get used.

• P/E ratio. This is one of the most common equity multiples since the data is the most available. It calculates the ratio of share price to earnings per share (EPS).

• Price-to-sales ratio. This ratio is easy to calculate and can be applied to companies in losses. It’s calculated by comparing share price to sales revenue per share. 

• Price-to-book ratio. This ratio can be extremely helpful for industries where assets  drive earnings. It gets calculated by using the share price to book value per share. 
• Dividend yield. You can use this ratio to compare cash returns and different investment types. You calculate it by dividing the dividend per share with share price. 

Enterprise value multiples are effective when it comes to things such as mergers and acquisitions. It helps remove any effect that debt financing might have. Here are some of the most common enterprise value multiples:

• Revenue ratio. This type of ratio might get affected if there are differences in accounting. You calculate it by taking into account the proportion of enterprise value to sales or revenue. 

• Earnings before interest, tax, depreciation, amortization, and rental costs ratio. This is most commonly used in the hotel and transport industries. You calculate it by comparing EBITDA with the enterprise value. 

Even if there isn’t a change in the enterprise value, equity multiples can get used to impact a change in capital structure. 

How Do You Use the Multiples Approach? 

Using the multiples approach can vary slightly depending on what the investor or analyst wants to consider. But typically, an investor will start the multiples approach by identifying similar companies. From here, they can start to move further by evaluating their individual market values. 

Once that information is gathered, a multiple gets computed for both of the comparable companies. It’s then translated into a more standardized figure using key statistics measures. These can include things like the median or mean, for example. 

What value gets identified as the key multiple then gets applied to the corresponding value. And this is for the business that’s getting analyzed. When this happens you can estimate the total value of the company. 

It’s worth mentioning that using the multiples approach should implement a forecast of profits. Forward-looking multiples are usually more consistent with the type of valuation. It’s basically a way of determining that a company’s specific value can equal its present value of future cash flows. 

What Are the Advantages and Disadvantages of the Multiples Approach? 

Depending on what you’re using the multiples approach for, it can bring a few advantages and disadvantages. 

Even though it might sound the opposite, one of the biggest disadvantages is that it simplifies complex data. It takes all of the information and breaks it down into a single value instead of a series of values. When this happens, it doesn’t paint the full picture in regards to a company’s value.

But on the flip side, the simplicity of the information can provide analysts an advantage. When everything gets simplified it can be easier to make fast decisions. This can speed up the process of assessing the value of a company. 

The multiples approach can also bring a little bit of difficulty when it comes to comparing assets and companies. But isn’t the multiples approach meant for comparing, you ask? Yes, it is. But some companies use different accounting processes than others. 

This can lead to misinterpretation which might make a comparison inconclusive. To account for this, it’s important to make necessary adjustments for various accounting policies. 

What Are Some of the Methods of Using the Multiples Approach? 

When it comes to using the multiples approach, there are two primary approaches to use. They are the comparable company analysis and the mergers and acquisitions transactions. 

Comparable Company Analysis 

Using this type of multiples approach is a great way to analyze more than one company. You take into consideration public companies that offer similar things to the company you’re valuing. 

This can include compiling share prices, capital structure, and market capitalization. Plus, you look deeper into things like revenue and overall earnings for each company. 

Precedent Mergers and Acquisitions Transactions 

When you use this type of multiples approach, you analyze the past mergers and acquisitions. It’s important to note that when doing this, the companies should be within the same industry. This information can then get used as a reference point against the company getting valued.

Summary

There can be a lot of moving parts that go into a potential investment. You want to do everything you can to gain as much information as possible. This will give you the best opportunity of finding the right investment.

The multiples approach is a specific valuation theory that you can use. Basically, it’s the concept that when you have a company with similar assets to another, they’re at similar prices. Taking this approach considers everything from cash flows to operating margins. 

It’s essentially a way to compare companies using similar financial metrics. By finding the value of one company, you can estimate the value of another. 

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.