Introduction to Multiples for Valuation

In this article, we’re going to explore Multiples for Valuation, including what it is, how it works, and some of the most important things we want to bear in mind. Let’s get into it.

Ultimately, Multiples for Valuation is one of the easiest and most common valuation techniques out there.

It’s often called Relative Valuation or Comparables Valuation, or simply “Comps” Valuation.

And there’s a good reason for this, as you’ll see in just a bit.

Multiples for Valuation relies on the use of “multiples” to determine the price of a security or a stock.

What are Multiples?

Firstly, what are Multiples?

Well, they’re essentially factors that we use to estimate the value for security or a stock. Or indeed, even houses.

A Valuation Multiple is a function of two things, including:

• the stock price, and
• a driver of value

Driver of Value

Now, what do we mean by a driver of value?

A driver of value is something that drives or causes the value to increase (or decrease).

Examples of drivers of value include things like:

• earnings (aka profit),
• revenue (aka turnover, sales),
• assets

To an extent, generally speaking, Multiples are ratios.

They tend to be one number divided by another number, although they don’t necessarily need to be ratios.

For the most part, though, you’ll likely end up working with Multiples as ratios.

And the type of valuation multiple you use largely depends on the driver of value. For instance, if you use earnings-based drivers, then you’re using what’s called an earnings multiple.

If on the other hand, you’re using a revenue-based driver of value, then you’re using a revenue multiple.

Equally of course, if you consider the valuation multiple as a whole (i.e., not just in terms of the core driver of value), then we can think of multiples as being:

• price multiples (those where the multiple has an expression for “price”)
• cash flow multiple (those where the multiple has an element of cash flow in it, e.g. “operating cash flow”)
• equity multiple (those where the multiple has an “equity” element, or a book value element)

Now, since they’re typically ratios, we can rearrange these ratios to obtain an expression for the price of a stock.

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To give you an example, one of the most popular investor ratios is the Price to Earnings Ratio (PE ratio).

As the name kind of suggests, the PE ratio is the price relative to the earnings.

So it’s the Stock Price divided by the Earnings Per Share (EPS). In other words…

   

Where refers to the stock price, and reflects the Earnings Per Share.

Now, we’ve got a whole other article that talks about the PE ratio in great detail. But the only thing you need to know for now is the fact that this is one of the most popular ratios out there.

And what we can do essentially, is rearrange this equation to gain, or to obtain, an expression for the price of a stock.

So what does that look like?

Well if we just divide both sides by the equation would then become…

   

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And so this is an example of using Multiples for Valuation, right?

We’re saying the price of a stock is equal to some valuation multiple, which in this case is the Price to Earnings ratio, multiplied by a driver of value, which in this case is the Earnings Per Share.

Generalised Equation for Multiples Valuation

Now, if we were to generalise this to any multiple, as opposed to just the Price to Earnings ratio, and any driver of value, as opposed to just the EPS, then we could say that the price of a stock is given by…

   

Where is a Multiple (aka factor), and is some Driver of Value.

Now, strictly speaking, this equation isn’t quite right.

And that is because, generally speaking, the Multiple that we use to value a stock is of a comparable firm or comparable firms, rather than the Multiple of the firm that we’re actually valuing.

And this is precisely why Multiples for Valuation is also called Relative Valuation or Comparables Valuation.

Because we’re coming up with a valuation estimate relative to another firm.

Put differently, we’re coming up with a valuation for a firm based on the firm’s comparables; or based on the comparable firms of our target firm.

And so if you wanted to obtain the value for Company A using the PE Ratio as your Multiple, you would need to multiply Company B’s Price to earnings ratio with Company A’s EPS.

Thus, you’d estimate it as…

   

Obviously, we don’t want to limit this to the Price to Earnings ratio exclusively.

So we can generalise this equation and say that the price of any stock is equal to the Multiple of a comparable stock , multiplied by the driver of value of stock . That is…

   

Identifying a Core Comparable

Remember that and are just generic terms.

could be anything – for instance, Google or Apple Inc., or Facebook, Snapchat, Spotify or whatever you like.

And would then be a comparable firm of . So if you think of as say, Apple Inc., then you might argue that a comparable firm would be something like Samsung or perhaps Microsoft.

Or indeed, Alphabet (formerly, Google) with their pixel phone and the Android software and so on and so forth.

Now importantly, the comparable firm needs to be as similar to the target firm as physically possible. In fact, ideally it should be identical to the firm that you’re trying to value.

Thus, already, you may well have realised that if we just look at a simple case like Apple Inc., well, how do we find a comparable firm that is identical to Apple?!

Perhaps that’s impossible.

It might be more realistic to look for a similar company; close, but not identical.

But equally, even finding a firm that’s a good or close comparable to Apple is not so easy.

It’s so challenging in fact, that a large part of our course on Stock Valuation using Multiples is dedicated to precisely that problem – identifying the correct comparable.

But perhaps you’re wondering, why is it actually so important to find an incredibly similar comparable firm?

The reason this is so important is that the use of another comparable firm’s Multiple relies on the Law of One Price.

The Law of One Price

What’s the Law of One Price?

In a nutshell, the Law of One Price says that any two identical assets with identical risks and rewards must have identical prices.

Therefore, if you have two stocks that are identical in all aspects, then they must be trading at the same price.

This really is an incredibly important concept, not just for Multiples for Valuation, but for finance as a whole.

So if you’re not familiar with it, we strongly recommend reading our article on Investment Fundamentals: Price, Risk, & Return.

We explain the Law of One Price in a  lot more detail there, too.

Common Valuation Multiples

Now, just before we close off, let’s explore some of the most common valuation multiples that are used by investors across the globe.

Price Multiples

Common Price Multiples include the Price to Earnings Multiple, and the Price to Sales Multiple.

Some investors also use the Enterprise Value as a multiple, and this is alright as long as you remember that you’re dealing with a firm-level variable and not a stock-level one.

We’d argue that the Market to Book (MTB) multiple can also be thought of as a Price multiple.

But equally, you could argue that it’s more appropriate to think of it as an Equity Multiple. And that certainly wouldn’t be wrong.

Earnings Multiples

You could of course think of the Price to Earnings Multiple as an Earnings based Multiple (in addition to a Price based one).

Other common/popular earnings multiples include the EBITDA Multiple and EBIT Multiples.

EBITDA is the abbreviation for Earnings Before Interest, Tax, Depreciation, and Amortisation. Those terms are way outside the scope of this article…

But, you can think of EBITDA as an operating profit without the distortions created by accounting conventions!

If you don’t know what EBIT is, can you venture a guess given the definition/expansion of EBITDA above?

Cash flow Multiples

The most popular cash flow Multiple is perhaps the Price to Operating Cashflow Multiple.

But, as with any Multiple, there’s no reason you can’t create your own cash flow Multiples.

For instance, you could take the cash flows from investments as the denominator (instead of cash flows from operations) to create your own “Price to Investing Cashflow Multiple”!

Equity Multiples

As highlighted above, you could well argue that the MTB is an Equity Multiple. And on that note, the BTM (or Book to Market multiple) can also be seen as another Equity-based Valuation Multiple.

Wrapping Up

Alright, in summary…

You learned that Multiples for Valuation, aka Relative Valuation, or Comparables Valuation, or “Comps” Valuation, is one of the easiest and most common valuation techniques out there.

Perhaps most importantly, it relies on the Law of One Price, which says that any two identical assets that have identical risks and rewards must have identical prices, failing which, an arbitrage opportunity exists.

And so rational investors, or “arbitragers” would exploit this opportunity until the prices ultimately do converge.

Furthermore, you learned that a Valuation Multiple is essentially just a factor, typically a ratio, which we use to estimate the value for a stock.

We essentially do this by rearranging an equation to gain or obtain an expression for the price.

Thus, in a nutshell, we can estimate the price of a stock as…

   

Hopefully, this makes sense. If any part of the article isn’t quite clear, please do give it another read. If you’d like to learn more about How to Calculate Stock Price using other techniques, then do give our sister article a read.

Importantly, in the real world, it’s extremely difficult and perhaps impossible to find two perfectly identical stocks.

Having said that with a solid foundation and a good robust system, it is possible to find a comparable company / similar company.

And that’s what we teach and help you master in our course on Stock Valuation using Multiples. Explore the course below!

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