1.5whenthetruereasonmaybethatthelatterhasamuch
higher return on equity.
Relationship
Knowing the fundamentals that determine a multiple is a
usefulfirststep,butunderstandinghowthemultiplechanges
as thefundamentals changeis just as critical to using the
multiple.Toillustrate,knowingthathigher-growthfirmshave
higherP/Eratiosisnota sufficientinsightifwearecalled
uponto analyzewhether afirmwith a growth ratethat is
twiceashighastheaveragegrowthrateforthesectorshould
haveaP/Eratiothatis1.5timesor1.8timesor 2 timesthe
average price-earnings ratio for the sector. To make this
judgment,weneedtoknowhowtheP/Eratiochangesasthe
growth rate changes.
Asurprisinglylargenumberofvaluationanalysesarebased
ontheassumptionthatthereisalinearrelationshipbetween
multiples and fundamentals. For instance, the PEG ratio,
whichistheratiooftheP/Etotheexpectedgrowthratein
earningsofafirmandwidelyusedtoanalyzehigh-growth
firms,implicitlyassumesthatP/Eratiosandexpectedgrowth
rates are linearly related.
One of the advantages of deriving the multiples from a
discounted cash flow model, as was done in theprevious
section,isthatwecananalyzetherelationshipbetweeneach
fundamentalvariableandthemultiplebykeepingeverything
elseconstantandchangingthevalueofthatvariable.When
we do this, we will find that there are very few linear
relationships in valuation.