This paper aims to present a selection of the most used multiples and to point out their strengths and weaknesses. The financial markets have been deeply shaken by the spread of Covid-19 and the recent oil price shock. Also, the financial market crisis in 2008/2009 or the dotcom bubble in 2000, where many investors lost money, remain in bad memory for them. Therefore, when entering the stock market, the question arises which shares are worthwhile in the long run and at what price an investor should buy them.
There are different approaches to answer this question - one of them is the multiples approach, which has become a popular instrument for investors and financial analysts due to its simple statement and handling. According to the Merrill Lynch Institutional Factor Survey, the most popular factor used by institutional investors in stock selection was the price-earnings ratio (P/E ratio) followed by other multiples. First, the multiples approach in general is described. Afterwards, the P/E ratio with its variants is discussed in detail and in the third section, other frequently used multiples are presented. Finally, a critical appraisal is given.
Table of Contents
1 Introduction
2 The Multiples Approach
2.1 Basic Concept and Procedure
2.2 Creation of multiples and calculation of the company value
2.3 Equity value multiples vs. Enterprise value multiples
3 The P/E ratio
3.1 Fundamentals
3.2 The Trailing P/E ratio
3.3 The Forward P/E ratio
3.4 Forward vs. Trailing P/E ratio
3.5 The PEG ratio
3.6 Determining factors of the P/E ratio
4 Other frequently used multiples
4.1 The P/B ratio
4.2 The P/S ratio
4.3 The EV/EBITDA ratio
5 Critical appraisal
Objectives and Topics
This paper aims to provide an overview of the multiples approach in stock valuation, identifying the most commonly used financial multiples while analyzing their respective strengths and limitations in determining company value.
- The theoretical foundation and practical application of the multiples approach.
- A detailed analysis of the Price-Earnings (P/E) ratio and its variants (Trailing, Forward, PEG).
- The evaluation of other essential market-based multiples, including P/B, P/S, and EV/EBITDA.
- A critical assessment of the objectivity and accuracy of market-based valuation methods.
- Illustrative examples demonstrating the practical implementation of various valuation multiples.
Excerpt from the book
2.1 Basic Concept and Procedure
The valuation with multiples represents a market-oriented valuation approach, which is based on existing market prices and thereby on information already processed in the market. In practice, this approach has become increasingly important and is one of the most widely used business valuation methods besides the DCF method (Stober, 2018, p. 1). This is due to the fact that the multiples valuation is relatively easy and quickly provides an initial indication of the company’s value. In principle, multipliers can be used for the following purposes: (1) the verification of company values that have been determined with other methods, (2) the assessment of the value of a company by comparing the multiples of this company with those of other companies and (3) for the valuation of a company based on multiples of comparable companies. Following this, the valuation with multiples is based on the assumption that similar companies are evaluated similarly to the company to be evaluated (Ernst et al, 2012, p. 223).
As a prerequisite, the market of competing companies or companies from the same industry must be subject to the correct valuation and the companies to be compared must develop similarly (Coenenberg and Schultze, 2002, p. 697; Buchner and Englert, 1994, p. 1573). The typical sequence of company valuation with multiples is illustrated in Appendix 2. First, companies that are comparable to the company to be evaluated must be identified – this group of companies is also referred to as a peer group. After that, all required information for the creation of the multiples must be compiled and processed. The multiples for the peer group derived from the processed information are then aggregated to a single multiple by calculating the median or mean value. In the end, this aggregated multiple is used to calculate the value of the company to be evaluated. However, there are often very few or no comparable companies within the industry or the required data basis is not available. Therefore, adjustments must ultimately always be made through assumptions and estimates.
Summary of Chapters
1 Introduction: Provides context on market volatility and the growing popularity of the multiples approach for stock selection.
2 The Multiples Approach: Outlines the fundamental methodology, the selection of peer groups, and the mathematical assumption of linear relationships in valuation.
3 The P/E ratio: Analyzes the most standard valuation metric, covering trailing and forward variants, the PEG ratio, and the underlying determinants of the ratio.
4 Other frequently used multiples: Examines alternative metrics such as P/B, P/S, and EV/EBITDA ratios as specific tools for different industry needs.
5 Critical appraisal: Summarizes the strengths and inherent challenges, such as subjectivity in peer selection and the risk of over-simplification in valuation.
Keywords
Stock Valuation, Multiples Approach, P/E Ratio, Equity Value, Enterprise Value, PEG Ratio, Peer Group, Market Capitalisation, Financial Analysis, P/B Ratio, P/S Ratio, EV/EBITDA, Valuation Metrics, Investment Strategy, Earnings Growth.
Frequently Asked Questions
What is the primary focus of this work?
The paper focuses on the multiples approach as a primary method for fundamental stock valuation, examining how investors use market-based ratios to assess company value.
What are the central themes discussed in this document?
The central themes include the mechanics of the multiples approach, the interpretation of the P/E ratio and its derivatives, and the utility of alternative metrics like P/B, P/S, and EV/EBITDA.
What is the core research goal?
The goal is to provide a comprehensive guide on how multiples are created and applied, while clarifying the strengths and limitations of each metric for practical investment decisions.
Which scientific methods are employed?
The author uses a descriptive and analytical approach, synthesizing existing literature on corporate finance and valuation, supported by practical industry examples.
What topics are covered in the main section?
The main section covers the conceptual framework of the multiples approach, specific ratio analysis (P/E, PEG), and a critical appraisal of the approach's reliability in varying market conditions.
Which keywords define this publication?
Key terms include valuation, P/E ratio, multiples, peer group, earnings, and equity analysis.
Why is the P/E ratio considered the most popular factor?
The P/E ratio is widely utilized because it is intuitive, easy to calculate, and directly relates the market price of a stock to the company's profitability.
How does the EV/EBITDA ratio differ from the P/E ratio?
The EV/EBITDA ratio uses Enterprise Value and operating earnings, making it more suitable for capital-intensive businesses and independent of a company's specific financial leverage or debt structure.
What role does the "peer group" play in multiples valuation?
The peer group acts as the benchmark; the valuation of a target company is derived from the aggregated multiples of similar companies in the same industry.
What is the limitation of the P/S (Price-to-Sales) ratio?
The primary limitation is that it ignores profitability entirely, which can lead to misleading valuations if companies have vastly different profit margins.
- Quote paper
- Anonym (Author), 2020, Stock Analysis Methods. The P/E Ratio and other Multiples, Munich, GRIN Verlag, https://www.grin.com/document/916279
