potential than the average firm in the industry. If, in the
judgmentoftheanalyst,thedifferenceonthemultiplecannot
beexplainedbythefundamentals,thefirmwillbeviewedas
overvalued (if its multiple is higher than the average) or
undervalued (if its multiple is lower than the average).
Theweaknessinthisapproachisnotthatanalystsarecalled
upontomake subjectivejudgments,but thatthejudgments
areoftenbasedonlittlemorethanguesswork.Alltoooften,
these judgments confirm analysts’ biases about companies.
Modified Multiples
Inthisapproach,wemodifythemultipletotakeintoaccount
themost importantvariabledetermining it—thecompanion
variable.To providean illustration, analysts whocompare
P/Eratiosacrosscompanieswithverydifferentgrowthrates
oftendividetheP/EratiobytheexpectedgrowthrateinEPS
to determineagrowth-adjusted P/Eratioor thePEGratio.
Thisratioisthencomparedacrosscompanieswithdifferent
growth rates to find under- and overvalued companies.
Therearetwoimplicitassumptionsthatwemakewhenusing
these modified multiples. The first is that thesefirms are
comparableonalltheothermeasuresofvalue,otherthanthe
one beingcontrolled for.In otherwords, whencomparing
PEGratiosacrosscompanies,weareassumingthattheyare
allofequivalentrisk.Theotherassumptiongenerallymadeis
thattherelationshipbetweenthemultiplesandfundamentals
islinear.Again,usingPEGratiostoillustratethepoint,we
are assuming that as growth doubles, the P/E ratio will
double;ifthisassumptiondoesnotholdupandP/Eratiosdo