Applicability of Multiples and Limitations
Theallureof multiplesisthattheyaresimpleand easyto
relate to. They can be used to obtain estimates of value
quicklyforfirmsandassets,andareparticularlyusefulwhen
a large number of comparable firms are being traded on
financialmarkets,andthemarketis,onaverage,pricingthese
firmscorrectly.Infact,relativevaluationistailor-made for
analystsandportfolio managerswhonotonly havetofind
undervalued equities in any market no matter how
overvalued,butalsogetjudgedonarelativebasis.Ananalyst
whopicks stocksbased ontheir P/E ratios relative to the
sectorsin whichtheyoperate willalways findundervalued
stocksinanymarket;ifentiresectorsareovervaluedandhis
stocksdecline,hewillstilllookgoodonarelativebasissince
hisstockswilldeclinelessthancomparablestocks(assuming
the relative valuation is right).
By thesametoken, multiplesarealso easy to misuse and
manipulate, especially when comparable firms are used.
Giventhatnotwofirmsareexactlyalikeintermsofriskand
growth,thedefinitionofcomparablefirmsisasubjectiveone.
Consequently, a biased analyst can choose a group of
comparablefirmstoconfirmhisorherbiasesaboutafirm’s
value.WhilethispotentialforbiasexistswithDCFvaluation
aswell,theanalystinDCFvaluationisforcedto bemuch
moreexplicitabouttheassumptionsthatdeterminethefinal
value. With multiples, these assumptions are often left
unstated.
Theotherproblemwithusingmultiplesbasedoncomparable
firms is that it builds in errors (overvaluation or
undervaluation)thatthemarketmightbemakinginvaluing