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FN-628-E
April 2016

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Multiples in Firm Valuation

1. Introduction

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There are two main methods for valuing companies: those based on discounted cash flow (DCF)
techniques and those based on multiples. This note focuses on the second type.

Valuation methods that use multiples are based on identifying companies that are similar to
the one we want to value. These similar companies are called “comparable firms,”
“comparables” or simply “comps.”

Multiples valuation is based on the assumption that markets will price equivalent assets in a
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similar way and therefore the value of a company can be derived by calculating the market
value of comparable firms. A comparable firm is a firm that operates in the same industry and
has similar key financial parameters (i.e., growth and profitability) as the firm we want to
value.

In order to be able to compare companies, we use “multiples” in which the value of a company
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(e.g., its share price or total enterprise value) is referenced to some financial item (e.g., its
earnings, EBITDA or revenue). Commonly used multiples include the price-to-earnings ratio
(P/E ratio or PER), the ratio of enterprise value to EBITDA (EV/EBITDA or EBITDA multiple)
and the ratio of enterprise value to sales.

In summary, to determine the value of firm XYZ, we can use the multiple of its comparable
firm or set of comparable firms, as follows:
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(Value of firm XYZ) = (Multiple of XYZ’s comparable firms) × (Firm-specific variable of firm XYZ)
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This technical note was prepared by Professor Carles Vergara-Alert and Arnau Gil, researcher. April 2016.

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FN-628-E Multiples in Firm Valuation

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The following example shows how to price the stock of a firm using the P/E ratio multiple.

Example 1: We want to find out whether firm XYZ’s stock price of €30 per share is too high. The
earnings per share (EPS) of XYZ are €1.20. XYZ’s best comparable firms are ABC and DEF, which
present stock prices of €20 and €40 per share and EPS of €1.25 and €2.00, respectively. Is the stock

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price of firm XYZ (€30 per share) overpriced?
Let us use the price-to-earnings ratio as the multiple. The P/E ratio of firm ABC is its stock price
divided by its EPS – that is, 20 / 1.25 = 16. Equivalently, the P/E ratio of firm DEF is 40 / 2.00
= 20. The average P/E ratio of both comparable firms is the average of 16 and 20 – that is, 18.
Therefore, the multiple of XYZ’s comparable firms is 18.
The implied value of the stock price of firm XYZ is the multiple of XYZ’s comparable firms (18)
multiplied by the EPS of XYZ (€1.20) – that is, €21.60. Hence, XYZ’s actual stock price of €30

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looks high compared with the price obtained with a multiples valuation using the P/E ratio with
ABC and DEF as comparable firms.

2. Types of Multiples
There are two main types of multiples depending on the reference on which they are based:
transaction multiples and trading multiples.
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Trading vs. Transaction Multiples
Trading multiples are calculated using information about similar companies that are traded
on the stock market. Example 1 showed the use of trading multiples. Multiples are expressed
relative to current or future performance.
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Transaction multiples are based on precedent merger and acquisition (M&A) transactions in which
the target company can be compared with the firm we want to value. Value includes takeover
premium, and multiples are expressed relative to the target company’s historical financials.

Example 2: We want to acquire firm XYZ. Therefore, we need to estimate its value in order to negotiate
the acquisition. XYZ’s EBITDA is €5 million and it has no debt. XYZ’s best comparable firms are ABC,
DEF and GHI, which have been acquired recently for a total value of €40 million, €60 million and
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€11 million, respectively. The EBITDA of the three acquired firms are €8 million, €10 million and
€2 million, respectively. None of the companies has debt. What is the fair acquisition value for XYZ?
Let us use the comparable transaction analysis to estimate a fair acquisition value for XYZ. The
EV/EBITDA ratio of firm ABC is its acquisition enterprise value (EV) divided by its EBITDA – that
is, 40 / 8 = 5. Equivalently, the EV/EBITDA of firm DEF is 60 / 10 = 6 and the EV/EBITDA of firm
GHI is 11 / 2 = 5.5. The average EV/EBITDA ratio of the three comparable firms is the average of
5, 6 and 5.5 – that is, 5.5. Therefore, the average multiple of XYZ’s comparable firms is 5.5.
The estimated value for XYZ is the mean multiple for comparable transactions (5.5) multiplied by
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the target company’s valuation variable (EBITDA) of XYZ (€5 million) – that is, €27.5 million.

Enterprise Value-Based vs. Equity-Based Multiples

Enterprise value-based multiples are determined by the value of the whole company, which
consists of the market value of equity plus net debt (gross debt minus cash). This multiple is
not affected by financial leverage (debt levels) as enterprise value includes the value of debt,

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Multiples in Firm Valuation FN-628-E

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and EBITDA is available to all investors (debt and equity) as it excludes interest payments on
debt. The EV/EBITDA ratio is not influenced by capital structures, which makes it possible to
get a fair comparison of companies with different capital structures. The ratio is not affected
by the effect of noncash expenses such as depreciation and amortization.

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Another advantage is that there are far fewer firms with negative EBITDA than there are firms
with negative earnings per share. Unlike P/E ratios, EV/EBITDA ratios can be used to compare
a wide variety of companies. EV multiple valuation will need to be stripped out of net debt to
derive the equity value of the target company.

Example 3: The stock price of XYZ is €30 per share. We want to evaluate the stock of XYZ relative
to that of its peers. XYZ’s best comparable firms are ABC and DEF, which present stock prices of €14

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and €18 respectively. XYZ has five million shares outstanding, ABC has 21 million, and DEF has six
million. XYZ’s cash is €9 million, ABC’s cash is €55 million and DEF’s cash is €16 million. XYZ’s
debt (for the most recent quarter) is €7.4 million, ABC’s debt is €32 million and DEF’s debt is
€12.5 million. Their EBITDA figures (12 months) are €14.5 million for XYZ, €28.5 million for ABC
and €20 million for DEF. How does the stock price of XYZ (€30) look relative to that of its peers?
Let us calculate the market capitalization (i.e., the market value of equity) by multiplying the stock price
by the number of shares outstanding – that is, €14 × 21 million = €294 million for firm ABC, and €18
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× 6 million = €108 million for firm DEF.
Now, let us calculate ABC’s and DEF’s enterprise value as follows:
EV = Market capitalization + Debt − Cash
Therefore, the EV of ABC is €294 million + €32 million − €55 million = €271 million. Equivalently, the
EV of DEF is: €108 million + €12.5 million − €16 million = €104.5 million.
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Let us calculate the EV/EBITDA multiples for ABC and DEF:

ABC’s EV/EBITDA: €271 million / €28.5 million = 9.51
DEF’s EV/EBITDA: €104.5 million / €20 million = 5.23
The average of the EBITDA multiples of the two comparable firms is 7.37. Hence, the EV of XYZ is
€14,500,000 × 7.37 = €106,819,846.
Now, let us calculate XYZ’s market capitalization as follows:
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Market capitalization = EV − Debt + Cash

Therefore, the market capitalization of XYZ is €106,819,846 − €7,400,000 + €9,000,000 =
€108,419,846. Now, let us divide this market capitalization by the number of shares (five million) to find
the stock price – that is, €22. We can see that XYZ is trading at a higher price (€30) compared with the
price that we obtain using ABC and DEF as comparable firms (€22), so XYZ is relatively overvalued.

Equity-based multiples are based on either the market value of equity, calculated by
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multiplying the share price by the number of shares, or on the value of a single share. It is the
simplest multiple, and the price-to-earnings ratio is the most commonly used. There are two
major drawbacks: some reference parameters (e.g., earnings or net income) are vulnerable to
changing accounting standards, and net income is affected by capital structure. This makes it
difficult to use P/E ratios to compare companies with different leverage ratios. Example 1 above
showed the use of equity-based multiples.

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3. Identifying Comparable Firms
The best way to determine and identify a suitable combination of companies is to rely on a
sample from the target's own industry. These are the two basic steps for identifying
comparables:

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1) Defining a sample of comparable firms:
1. Use a standard industrial classification (e.g., SIC or GICS) to get an extensive list of
industry peers.
2. Narrow down the sample by testing for business focus and size (e.g., market
capitalization and sales).

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3. Test crucial variables such as growth, profitability and cash flow potential for
comparison.
4. Compare your list of comparable firms to the lists in analyst reports, industry
publications and credit rating agencies’ reports.
5. Take a further look beyond industry boundaries to gather a list of comparables based
on similar growth, risk, and performance patterns, both expected and historical.
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6. Cross-check your sample by:

 Looking at company publications. It may list its peer group in its annual report.
 Examining broker reports and reviewing their suggestions for a list of competitors.
 Checking out the list of companies in various industry indices.
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2) Looking at other factors:

7. Business mix: different products can increase at different rates and/or have very
distinct profitability levels, which is also a measure of risk.
8. Sales, assets, employees: these tell us about the size of the company.
9. Capital expenditure: the depth of investment in the business is a driver of future
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profit growth.
10. Geographical sales mix: this shows us whether we are dealing with developed or growth
markets and additionally it is a risk indicator.
11. Expected ROI, profit margin, cash flow pattern: these represent a firm’s ability to
generate profit in the future and its expected profitability. They are also a key driver in
DCF valuation.
12. Top/bottom line growth: future growth in sales, customers, capital, earnings, etc. These
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are a key driver in DCF valuation as well.

13. Cost of capital: this can indicate risk associated with the respective business.

In summary, in order to identify comparable firms we must focus on finding peers that are as
similar as possible to the firm that we want to value and then use the multiples appropriately.

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4. Historical vs. Forward-Looking Multiples
Trading multiples are usually based on current or forward-looking multiples. This forward-looking
approach is consistent with discounted cash flow valuations. Moreover, the empirical evidence
shows that forward-looking multiples are more accurate predictors than historical multiples.

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If there are no reliable forecasts available, then we must rely on historical data. We should
make sure we use the latest data possible for the most recent four quarters, not the most recent
fiscal year, and we should eliminate once-off events.

Transaction multiples are based on historical multiples, usually on the 12 months prior to the
transaction date.

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5. Selection of Multiples
What multiple should we choose to value a company? Should we use the P/E ratio? Or should
we use the EV/EBITDA ratio? There is a long list of variables to be used as multiples. The most
common multiples are the following:
14. Price/earnings.
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15. Price/book value of equity.
16. Price/operating cash flow.
17. EV/sales.
18. EV/EBITDA.
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19. EV/EBIT.

There are also sector-specific multiples, which provide useful adaptations of commonly used
multiples for specific industries, such as:
20. EV/EBITDAR (EBITDA + rental/operating lease expenditures): convenient for airlines,
restaurants and retail.
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21. EV/implied reserve value and EV/EBITDAX (EBITDA + exploration costs), which is
suitable for oil and gas companies.
22. EV/number of customers for Internet retailers whose value can be calculated in terms
of the number of regular customers and their average spend.
23. EV/number of subscribers for businesses that rely on subscribers for their revenue.
24. EV/number of beds for hotel chain.
25. EV/sales per seat mile for airlines.
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6. Adjustments to Align and Coordinate Input Data
There are a number of critical adjustments that need to be addressed:
26. Look over and check the fiscal year-end (Asian and British companies usually close
their books in March, others in June, others in December, etc.).

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27. Examine and correct for nonrecurring items such as restructuring costs and impairments.
28. Be cautious with acquisitions or disposals that might distort input data significantly.
29. Determine the impact of share issuance, buybacks or other adjustments on equity capital.
30. Avoid discrepancies that derive directly from different accounting standards.

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31. Adjust the enterprise value multiple to take account of hidden nonoperating items such as:
 Excess cash: do not take into account excess cash in EV and its interest income in EBIT.
 Pension accruals: add the present value of pension liabilities to the EV and remove
income or expenses relating to the pension assets from EBIT.
 Operating leases: add the market value of leased assets to the EV and add the
implied interest expense to EBIT.
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We must define multiples consistently and measure them in the same manner. We must have
a sense of how the multiple in question fluctuates and behaves (high/low/zero value). Look at
the maximum and minimum value of the multiple over time and its dispersion in the data to
learn how stable it is.
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7. Useful Tips
1) Contrasting multiples with DCF valuation techniques:
32. Relative valuation offers the advantage of simplicity at the expense of accuracy.
33. It is done more quickly than a DCF but the results are only indicative and not conclusive.
34. Multiples can be completed with a smaller number of explicit assumptions.
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35. It is straightforward to understand and easier to present to clients than a DCF valuation.
36. Lack of transparency with respect to the underlying assumptions can make them
difficult to interpret and use.
37. Multiples assume that the market is efficient in valuing assets.
38. Relative valuation can be used to countercheck DCF and evaluate and compare the
results of the two methods. It might provide rewarding insights into whether the
company's strategic position enables it to create superior value or generate insights into
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key factors involved in the sector's potential for value creation.

39. Use forward-looking data for your multiples when analyzing and comparing results to DCF.
40. When companies’ business segments serve different sectors and vary greatly in terms
of risk, it is better to value their performance and growth individually (sum-of-the-parts
valuation).

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8. Workflow and Conclusions
The workflow has various steps:
1. Select peers.

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2. Choose multiples.
3. Create input data.
4. Calculate multiples.
5. Apply multiples.
6. Interpret results.

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We should consider multiples over a suitable time period (e.g., over the business cycle) and
remember that different multiples can suggest contradictory conclusions. We must choose
multiples that are appropriate for the industry or business logic.

A multiples analysis that is well reasoned and careful will not only provide a useful check of
your DCF forecasts but also provide critical insights into what drives value in a given industry.
A few closing thoughts about multiples:
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1. Like DCF, enterprise value multiples are driven by the key value drivers, return on
invested capital (ROIC) and growth. A company with good prospects for growth and
profitability should trade at a better multiple than its peers.

2. A well-designed multiples analysis will focus on operations, will use forward-looking

earnings (rather than historical earnings) and will concentrate on a peer group with
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similar prospects. We must take into account that P/E ratios are problematic, as they
commingle operating, nonoperating and financing activities, and this leads to misused
and misapplied multiples.

In limited situations, alternative multiples can provide useful insight. Common alternatives
include the price-to-sales ratio, the adjusted price/earnings-to-growth (PEG) ratio, and
multiples based on nonfinancial (operational) data, such as enterprise value-based multiples.
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