Select Multiples

Overview and Application

This topic provides an overview of several commonly used multiples in relative valuation, outlining their calculation, interpretation, and appropriate application.

1. Price-Earnings (P/E) Ratio:

• Calculation: Market Capitalization / Net Income
• Interpretation: Represents the amount investors are willing to pay for each dollar of a company's earnings. A higher P/E ratio suggests that investors expect higher future growth or have greater confidence in the company's earnings.
• Variants:
  • Trailing P/E: Uses historical earnings (typically the past 12 months).
  • Forward P/E: Uses expected future earnings (typically the next 12 months).
• Applicability: Most useful for companies with stable earnings and a clear relationship between earnings and value.
• Limitations: Can be distorted by accounting practices, cyclicality, and negative earnings. Not useful for companies with losses.

2. PEG Ratio:

• Calculation: P/E Ratio / Earnings Growth Rate
• Interpretation: Adjusts the P/E ratio for the company's expected earnings growth rate. A lower PEG ratio suggests that the company is undervalued relative to its growth potential.
• Applicability: Useful for comparing companies with different growth rates.
• Limitations: Relies on accurate estimates of future earnings growth, which can be difficult to predict. May not be appropriate for companies with very high or very low growth rates.

3. Price to Book Ratio (P/B):

• Calculation: Market Capitalization / Book Value of Equity
• Interpretation: Represents the amount investors are willing to pay for each dollar of book value of equity. Book value reflects the historical cost of the company's assets.
• Applicability: Useful for valuing companies with significant tangible assets, such as banks, insurance companies, and real estate companies.
• Limitations: Book value is based on historical cost, which may not reflect current market values. Can be distorted by accounting practices. Less relevant for service or technology companies.

4. Enterprise Value to EBITDA Multiple (EV/EBITDA):

• Calculation: Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization
• Interpretation: Represents the value of the entire company (both debt and equity) relative to its operating cash flow (EBITDA).
• Applicability: A popular multiple for valuing companies with significant capital expenditures and depreciation. Useful for comparing companies with different capital structures and tax rates.
• Limitations: EBITDA does not reflect all cash flows (e.g., changes in working capital, capital expenditures).

5. Enterprise Value/Sales (EV/Sales):

• Calculation: Enterprise Value / Revenue
• Interpretation: Represents the value of the entire company relative to its revenue.
• Applicability: Useful for valuing companies with negative earnings or volatile earnings. Can be helpful in valuing early stage companies.
• Limitations: Revenue does not reflect profitability. Companies with high revenue but low profit margins may be overvalued.

6. Enterprise Value/Book Value (EV/Book Value):

• Calculation: Enterprise Value / Book Value of Total Capital (Total Capital = Book Value of Equity + Book Value of Debt - Cash)
• Interpretation: Represents the value of the entire company relative to the book value of its total capital.
• Applicability: Useful for valuing companies with significant tangible assets and for comparing companies with different capital structures.
• Limitations: Book value is based on historical cost, which may not reflect current market values.

7. Tobin’s Q:

• Calculation: Market Value of Assets / Replacement Cost of Assets. *In practice, often approximated as (Market Value of Equity + Debt) / Book Value of