Multiples Approach

By 
TIM SMITH
 
 
Reviewed by 
MARGARET JAMES
 
 
Updated Apr 1, 2021
What Is the Multiples Approach?
The multiples approach is a valuation theory based on the idea that similar assets sell at similar
prices. It assumes that the type of ratio used in comparing firms, such as operating margins or
cash flows, is the same across similar firms.

Investors also refer to the multiples approach as multiples analysis or valuation multiples. When
doing so they may refer to a financial ratio, such as the price-to-earnings (P/E) ratio, as the
earnings multiple.

KEY TAKEAWAYS

 The multiples approach is a comparables analysis or relative valuation method that seeks
to evaluate similar companies using the same standardized financial metrics.
 Enterprise value multiples and equity multiples are the two categories of valuation
multiples. 
 Commonly used equity multiples include P/E multiple, PEG, price-to-book, and price-to-
sales.
The Basics of the Multiples Approach
Generally, "multiples" is a generic term for a class of different indicators that can be used to
value a stock. A multiple is simply a ratio that is calculated by dividing the market or estimated
value of an asset by a specific item on the financial statements. The multiples approach is a
comparables analysis method that seeks to value similar companies using the same financial
metrics.

An analyst using the valuation approach assumes that a particular ratio is applicable and applies
to various companies operating within the same line of business or industry. In other words, the
idea behind multiples analysis is that when firms are comparable, the multiples approach can be
used to determine the value of one firm based on the value of another. The multiples approach
seeks to capture many of a firm's operating and financial characteristics (e.g., expected growth)
in a single number that can be multiplied by a specific financial metric (e.g., EBITDA) to yield
an enterprise or equity value.

Common Ratios Used in the Multiples Approach

Enterprise value multiples and equity multiples are the two categories of valuation multiples.
Enterprise value multiples include the enterprise-value-to-sales ratio (EV/sales), EV/EBIT, and
EV/EBITDA. Equity multiples involve examining ratios between a company's share price and an
element of the underlying company's performance, such as earnings, sales, book value, or
something similar. Common equity multiples include price-to-earnings (P/E) ratio, price-
earnings to growth (PEG) ratio, price-to-book ratio (P/B), and price-to-sales (P/S) ratio.

Equity multiples can be artificially impacted by a change in capital structure, even when there is
no change in enterprise value (EV). Since enterprise value multiples allow for direct comparison
of different firms, regardless of capital structure, they are said to be better valuation models than
equity multiples. Additionally, enterprise valuation multiples are typically less affected by
accounting differences, since the denominator is computed higher up on the income statement.
However, equity multiples are more commonly used by investors because they can be calculated
easily and are readily available via most financial websites and newspapers.

Using the Multiples Approach

Investors start the multiples approach by identifying similar companies and evaluating their
market values. A multiple is then computed for the comparable companies and aggregated into a
standardized figure using a key statistics measure, such as the mean or median. The value
identified as the key multiple among the various companies is applied to the corresponding value
of the firm under analysis to estimate its value. When building a multiple, the denominator
should use a forecast of profits, rather than historical profits.

Unlike backward-looking multiples, forward-looking multiples are consistent with the principles
of valuation—in particular, that a company's value equals the present value of future cash flow,
not past profits and sunk costs.

Example of the Multiples Approach

Let’s assume that an analyst wants to conduct the multiples approach to compare where major
banking stocks trade in relation to their earnings. They can do this easily by creating a
watchlist of the S&P 500's four largest banking stocks with each bank's P/E ratio, like in the
example below:

Trailing 12-mo. P/E for Top 4 Banks (as of April 1, 2021)

  Bank   Trailing P/E
 Wells Fargo 95.6
 Citigroup 15.4
Bank of America 20.8
JP Morgan Chase 17.2
Source: Yahoo! Finance
An analyst can quickly see that Citigroup Inc. (C) trades at a discount to the other three banks in
relation to its earnings, having the lowest P/E ratio of the group at 15.4x. Wells Fargo,
meanwhile, has a far larger P/E multiple nearing 100x, likely due to poor earnings that are
expected to turn around. The P/E ratio mean, or average, of the four stocks is calculated by
adding them together and dividing the number by four.
(95.6 + 15.4 + 20.8 + 17.2) / 4 = 37 average P/E ratio
The analyst now knows that Bank of America Corporation (BAC), JP Morgan (JPM), and
Citigroup all trade at a discount to the major bank P/E ratio mean using the multiples approach.

Related Terms

Multiple Definition
A multiple measures some aspect of a company's financial well-being,
determined by dividing one metric by another metric.
 more
Enterprise Value – EV
Enterprise value (EV) is a measure of a company's total value, often used as a
comprehensive alternative to equity market capitalization. EV includes in its
calculation the market capitalization of a company but also short-term and long-
term debt as well as any cash on the company's balance sheet.
 more
Multiple Compression Definition
Multiple compression is when a company's multiples such as the P/E ratio is
reduced due to increased earnings without an increase in stock price.
 more
What Does the Price-to-Sales (P/S) Ratio Reveal?
The price-to-sales (P/S) ratio compares a company's stock price to its revenues,
helping investors find undervalued stocks that make good investments.
 more
How the Price-to-Cash Flow (P/CF) Ratio Works
The price-to-cash flow (P/CF) ratio measures the value of a stock’s price relative
to its operating cash flow per share.
 more
Relative Value Defintion
Relative value assesses an investment's value by considering how it compares to
valuations in other, similar investments.
 more
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