Using multiples for evaluations is convenient and straightforward but it can also be very misleading. And that is an understatement.
Various multiples such as profit, capital, assets and sales multiples are used to compare various companies in terms of profitability, valuation, effectiveness and more. The most common use of profit multiples, for example, is in comparing valuations of similar companies in the same industry.
The advantages of using multiples are obvious:
1. Simplicity – Extrapolating data is easy and multiplying is very basic math.
2. Informative – Using multiples often yield significant data in a short time.
3. Does not require forecasts – Unlike other methods of valuations multiples use existing date (which is, of course, their Achilles heel).
However, one must also pay careful attention to the shortfalls of using multiples:
1. Sensitivity to various accounting choices and alternatives – A different method of revenue recognition adopted by a company might distort a profit multiplier quite badly.
2. Sensitivity to unique events – Unique revenues or expanses which should be corrected, valuation wise, will be effect multiples. These unique events could have very significant implications.
3. Ignores unique future circumstances for the company – Multiples rely on past data. A company just might have significant potential or benefiting circumstances which should be taken into account in a valuation.
4. Ignores various other issues
A direr problem with using multiples is that the search for similar companies often leads us to compare different companies entirely. In order to really identify similar companies we need to carefully examine growth, dividend pay-out ratio, discount rate and beta (Theory wise).
A much more preferred valuation method is of course DCF (or Discounted Cash Flows) which I will discuss in some length in the future.