For investors wanting to do a quick and dirty check on whether a firm is cheap or expensive, multiples can be helpful. As part of his short series on valuing companies, Tim Bennett explains why and how to go about using them.
Videos from this series
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How to value a company using net assets
How to value a company using discounted cash flow
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You can watch the introductory video here, and watch the video with the first method here.
This method is a useful check on whether your other methods are throwing out sensible numbers?
A predator, maybe looking to value a company, or looking to list a private company, and an investor wanting to check if the company they are looking at is good value relative to other companies, would use this approach.
If you're going to value anything using a multiple, you've got to pick the right multiple.
There is a way of using ratios to get a quick value of a company, but you need to use the right one depending on the company or sector.
If you're looking at a company based on a multiple, you've got various multiples, such as the P/E ratio.
Then there are sales-based multiples, such as the price to sales ratio.
There are also asset driven multiples: such as the price to book multiple
You always need to compare it to something that's similar; is it a company driven by earnings? Is it generating any earnings at all? Is it sales driven? Is it asset driven? This will influence the following suggestion.
Assuming you want to go down an earnings-based route, you can simply rearrange a p/e ratio, or a price to book ratio, or a price to sales ratio, to get a valuation.
If a P/E ratio for a particular company is 5, you can rearrange this by multiplying both sides by E, so the Price = 5 x E.
This is a very simplified method, but it can be useful if you're looking at a company that's already listed, as an investor, and trying to get comparison about whether it's cheap or expensive, you can compare the expected value against the actual value, to work out if the company is under or overvalued and worth investing in.
Somebody trying to bring a company to the market for the first time, if they can find comparable companies and average the P/E ratio, multiple their company's earnings by that, to get a ball park figure for what the new company is worth.
If you're in a negotiation to buy a company, you might use this as a backup to check how sensible your investment would be.
It's more art than science in so far as:
- You've got pick the right multiple
- Are you looking at earnings based, a sales based, an assets based company?
- You've got to have your benchmark right, making sure you are testing against comparable companies.
