This is “Market Multiples Approach”, section 10.3 from the book Finance for Managers (v. 0.1).
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If we try to compare two companies that are in the same line of buisness and approximately the same size, we would expect them to have certain features in common and, perhaps, behave in similar ways. This is the basis for a popular approach to stock valuation based called the market multiples approach.
“Market multiples” is a generic term for a class of many different indicators that can be used to value a stock. Probably the most familiar is using the price to earnings (P/E) ratio (first discussed in chapter 4), and it is used in the following manner: if we know that the average P/E ratio for companies in our sector is 25, and we know the expected earnings (that is, net income) per share of our company is $2 per year, then an appropriate valuation for our stock should be $2 × 25 = $50.
Of course, we can use a competitor’s P/E ratio, if we think it more appropriate than an industry average. Or we can use our company’s historic P/E ratio. Or a trending average over years. This approach is both versatile and simple to use, which might explain its popularity with the financial press.
But what do we do if earnings are expected to be negative? Does this imply that our stock price is also negative? Of course not! Many companies have emerged from negative earnings (perhaps due to a slumping economy) only to skyrocket in value. The simplicity of ratio analysis is its major weakness, as it is impossible to capture everything about a company in one ratio. Other ratios and metrics can be used, if we believe them to be a good indicator of the company’s value. Common ratios (many are mentioned in chapter 5) are price to book, price to EBIT, price to EBITDA, price to sales, etc. but virtually anything can be used if it is justifiable (price to headcount, price to watermelons…). It is important, however, that we don’t attempt to use ratios solely because they are convenient or only because they support the result we desire; we should try to use reason to explain why a given metric is useful, and examine the data to determine if a meaningful relationship exists to aid is in our valuation efforts.