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1 February 2013 CFA Institute Journal Review

Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies (Digest Summary)

  1. Nitin Joshi

Market multiples are commonly used to value a company. But it can be difficult to identify companies sufficiently comparable for valuation purposes. The authors summarize the key challenges to identifying and using comparable companies as part of a market multiple valuation.

What’s Inside?

Many corporations use market multiples as a valuation method in combination with discounted cash flow or other valuation techniques. Identifying appropriate comparable companies and normalizing their financial numbers are essential steps in the market multiple valuation method. The authors explore various value drivers for assessing the comparability of companies in a market multiple valuation method and the relative importance of those drivers for assessing comparability with different kinds of multiples.

How Is This Research Useful to Practitioners?

Company valuation is a key component in investment analysis, merger and acquisition transactions, capital budgeting, and financial reporting. Comparable company analysis is one of the methods that can be used to value companies. Identification of appropriate comparable companies is one of the key determinants of the effectiveness of this method. This process involves aligning the characteristics of the comparable companies with those of the company being valued by analyzing the differences in operating characteristics and their impact on various multiples.

The authors start with a free cash flow multiple that is equivalent to the capitalization factor in the constant growth perpetuity model. They illustrate that risk and growth are primary determinants of the comparability of companies when using multiples related to free cash flow. The authors conduct a valuation of Staples using a simple financial model and consider variation in different value drivers, such as risk, growth rate, financial leverage, cost structure, and investment requirements. They demonstrate that the higher the sensitivity of market multiples to change in a value driver, the more important that value driver is for assessing comparability.

Changes in risk and capital structure affect all multiples and should be roughly equivalent among all comparable companies and the company being valued. The authors show that differences in revenue growth rates can affect free cash flow multiples more than earnings-based or balance sheet–based multiples depending on the characteristics of the firm. Differences in operating cost structure are most important for assessing comparability when using balance sheet and revenue multiples. Differences in income tax cost structure are important in comparability analysis when using the following multiples: balance sheet; revenue; earnings before interest, taxes, depreciation, and amortization; and earnings before interest and taxes. Accounting for differences in investment requirements can be important for assessing comparability when using earnings, balance sheet, and revenue multiples.

How Did the Authors Conduct This Research?

The authors calculate the enterprise value of Staples and present selected years of forecasts for income statement, balance sheet, and cash flow schedules using a simple financial model with underlying assumptions for the discount rate, revenue growth rate, expenses, current and noncurrent assets, and liabilities.

They derive multiples based on total enterprise value and equity capitalization from Staples’ actual enterprise value, its equity value, and forecasts of relevant denominators of these multiples. The authors recalculate multiples based on enterprise value by inducing a variation in value drivers, which results in a 10% increase in the enterprise value of the company. Multiples based on equity value are recalculated for a change of 10.7% in the equity value of the company. The authors conclude that the sensitivity of multiples to a change in a value driver determines the importance of that value driver in assessing comparability of companies.

The authors consider the scenario of assessing comparability by using market multiples to measure continuing value. They conclude that this scenario requires using comparable companies that currently have value drivers similar to the expected value drivers of the company of interest.

Abstractor’s Viewpoint

The authors successfully demonstrate the effect of variation in value drivers on different kinds of multiples and how it is helpful in identifying appropriate comparable companies. It would be helpful to see the study expanded to include cyclicality effects on multiples and their impact on assessing comparability.

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