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Traduced from Intervalue

RELATIVE VALUATION. MULTIPLES

The discounted cash flow approach to valuation, explained in the previous post, is the correct method from a theoretical perspective. Nevertheless, applying in the real world is complex as it requires a lot of tough assumptions and estimations: mainly the WACC and the future cash flows (or alternatively, the expected growth rate). Estimating these parameters is more a prophecy than a reliable exercise. Thus, the usual approach is combining the discounted cash flow methodology with relative valuation.

This method consists in multiplying a financial result by a determined quantity. The classical example is the P/E ratio (Price to Earnings Ratio), that combines the net profit of the company with the market capitalisation (or alternatively, the Earning per Share (EPS) with the price of the stock), so that P/E=Price/EPS. As an example, if a company earns €10 per share, and its market price is €150, the P/E would be 15. Yet, the investor could think that the P/E should be more than that, for example, 20. The reason for this could be, simply, that the expected growth rate is larger than the market expectations, or even that the risk is lower. In addition, if similar companies trade at a higher P/E and the historical average is also greater, it could be a sufficient argument to estimate a higher ratio. In this particular example, if we estimate a P/E of 20, the intrinsic value per share would be €200 (10·20=200), whereas its price is €150. Thus, the upside is a 33%.

If the discounted cash flow valuation is well done, and the estimated P/E is right, both approaches should be equal, so, in the end, these two methods are equivalents.

Besides P/E, there are a lot of different multiples for firm and equity valuation. In this sense, the multiples can be divided depending on whether they value the firm or the equity. When the investor is valuing the whole company, to obtain the equity value it is needed to subtract the value of the debt, so both types of multiples should be equivalents. The typical multiples are the following.

Multiples.PNG

Although these are the most common multiples, every component of the company is susceptible of being multiplied. As an example, during the dotcom bubble, it was typical to use the multiple price per webpage visits (the larger the number of visits, the higher the price); or in real estate, price per square meter (the larger the number of square meters, the higher its price).

CONCLUSION

Company valuation requires technical knowledge and perspicacity to estimate in a precise manner. However, not even the most expert in valuation is able to make an exact valuation of the intrinsic value of a stock since the sensibility of the parameters is very strong and the future is unknown. So that, when doing an investment, it is always necessary to value different scenarios (in addition to the base scenario) or having a great safety margin to protect yourself form your errors.

Additionally, as we have seen previously, both approaches are just an approximation to value, so it is worth combining them to minimize the error. A good methodology is considering the average between DCF and relative value as the intrinsic value, as this number would protect the investor against extreme deviations.

In conclusion, firm valuation is a complex process with lots of exceptions and nuances, so that it is important to know the valuation techniques. Moreover, it is also important to have a deep knowledge of the company, the industry and the whole economy to manage to estimate the various parameters. In this sense, Damodaran shows that a good valuation is a mixture of numbers and narratives in which the most important part is the process, and not the final number.

 

SpreadsheetValuation Example