Fundamentals and Purpose

The Multiples Valuation (or Multiples Valuation) is the most widely used valuation technique in investment banking and stock analysis due to its speed and connection to current market reality. Unlike intrinsic valuation models (such as Discounted Cash Flow), which attempt to derive value from scratch based on future fundamentals, relative valuation operates under the premise of the Law of One Price: similar assets should trade at similar prices.

The purpose of this model is to determine a company's value by observing how the market is valuing its peers ("comps" or comparables). It is a benchmarking exercise. The underlying philosophy is that the market, on average, correctly values an industry, but can make pricing mistakes in individual companies.

This model answers the question: "How much are investors paying today for each euro of profit or sales in this specific sector?". It is a pricing tool, more than pure intrinsic value, and reflects current market sentiment and expectations.

Components and Calculation Mechanics

The mechanics are based on standardization. Since stock prices of companies of different sizes cannot be directly compared, ratios (multiples) are used that normalize value in relation to a key financial metric (earnings, sales, book value).

The General Formula

The estimated value of the target company (V_t) is derived by applying the sector's average multiple to the target company's financial metric:

The Two Types of Multiples

It is critical to distinguish between equity and enterprise multiples:

1. Equity Multiples (Market Value): Focus on what shareholders receive. The most common is the P/E Ratio (Price to Earnings).

2. Enterprise Value Multiples (Enterprise Value - EV): Value the entire firm (Debt + Equity), eliminating the effect of capital structure. The gold standard is EV/EBITDA.

Practical Application and Use Cases

The multiples valuation process requires subtle art in selecting comparables. The process consists of three steps: Selection, Calculation, and Adjustment.

Use Case: Valuation of a Retail Chain

Let's imagine we want to value "Retail Express", a company that is not publicly traded or we want to know if it is misvalued.

Retail Express Data (Target):

• EBITDA (last 12 months): €50 Million

• Net Debt: €100 Million

• Number of Shares: 10 Million

Step 1: Analysis of Comparables (Peers) We select 3 listed competitors with similar business models:

• Competitor A: Trading at 8.0× EV/EBITDA.

• Competitor B: Trading at 9.5× EV/EBITDA.

• Competitor C: Trading at 7.5× EV/EBITDA.

Step 2: Average Calculation

Step 3: Application to the Target Company First we calculate the theoretical Enterprise Value (EV):

To arrive at the equity value, we subtract debt (since the buyer must assume it):

Finally, the estimated price per share:

Decision: If Retail Express is currently trading at €25, it is undervalued relative to its peers. If trading at €40, it is overvalued (or the market expects higher growth than its rivals).

Methodological Criticism and Limitations

Despite its popularity, multiples valuation is prone to simplification errors and market traps.

The "Lemming" Problem (Sector Bubbles) The most serious limitation is that it is a relative, not absolute valuation. If an entire sector is massively overvalued (like tech in 2000), multiples valuation will tell you a stock is "cheap" simply because it is less expensive than others. It does not warn you if the entire industry is heading toward a cliff.

The "Perfect" Comparable Trap No company is identical to another. Differences in growth rates, regulatory risk, margins, or geography can justify a company trading at a premium or discount to its average. Blindly applying an average without adjustments (premiums/discounts) leads to serious errors.

Comparison with Discounted Cash Flow (DCF)

Frequently Asked Questions and Investor Adjustments

Which multiple should I use: P/E or EV/EBITDA?

Depends on the industry.

• Use P/E for financial companies (Banks, Insurers) where debt is part of inventory, or stable companies with similar capital structures.

• Use EV/EBITDA for capital-intensive industries (Telecommunications, Industrials) or to compare companies with different debt levels, as EBITDA is neutral to financial and tax structure.

• Use P/S (Price to Sales) for companies not yet generating profits (Startups, growing Tech) or cyclical companies in loss periods.

Should I use "Trailing" or "Forward" multiples?

• Trailing (Last 12 months): Based on actual reported facts. More conservative but looks in the rearview mirror.

• Forward (Next 12 months): Based on analyst estimates. More relevant for stock valuation (which discounts the future) but introduces estimation error risk. Standard practice is to look at both.

How do I adjust if the company is much smaller than its peers?

You should apply an "Illiquidity Discount" or size discount. Generally, large companies (Large Caps) trade at higher multiples than small ones (Small Caps) due to their safety and liquidity. If comparing a small company with giants, you should reduce the target multiple by a certain percentage for prudence.

The Final Verdict: When to Use It?

Multiples Valuation is the "sanity check" tool par excellence. It should rarely be used in isolation to make a long-term investment decision, but is indispensable for understanding price context.

You should use Multiples Valuation if:

• You need a quick valuation and don't have time or data for a complex DCF.

• You want to know if the market is being irrationally optimistic or pessimistic about a stock relative to its competitors.

• You are evaluating an Initial Public Offering (IPO) or acquisition, where the price is set almost exclusively by comparing with similar companies.

It's the method that tells you if the house you want to buy is expensive compared to the rest of the neighborhood, even though it doesn't tell you if the neighborhood's foundations are solid.