2. The "Theory"

Multiples are standardized measures of market value. Relative valuation essentially consists of the following four steps:

·         Find comparable firms or comparable transactions for which you have market values (MV).

·         Select an easily observed variable that is closely related to the firms’ ability to generate value. This is the so-called value indicator (VI).

·         Compute the valuation multiple by dividing the comparable’s market values with the respective valuation indicator.

·         Multiply your firm’s valuation indicator with the multiple you have just computed.

 

The following equation summarizes the procedure. Suppose we know the valuation of a comparable firm C, which we want to use to estimate the value of a potential target firm T. The basic equation for relative valuation is:

  

\( \text{Market value}_T=\frac{\text{Market value}_C}{\text{Value indicator}_C} \times \text{Value indicator}_T \)

   

The element \( \frac{\text{Market value}_C}{\text{Value indicator}_C} \) is the comparable firm's valuation multiple. It indicates, how much the market is willing to pay per dollar of value indicator.

   

Let's practice relative valuation with a real-life example: We want to use valuation multiples to estimate the value of Mars, Inc. With total sales of approximately $30 billion in 2015, Mars is the third largest private company in the U.S., according to the Forbes magazine.

Because the company is not listed on a stock exchange, it does not have to disclose financial information to the public.  Suppose the sales figure of $30 billion is the only available piece of financial information about the company. Can we still gauge its potential market value as of  2015?

  

To find an answer, let’s go through the four steps outlined above:

  • Comparable company: Because of the similar business model, we choose Kraft Foods Inc. as the comparable company. To keep things simple, we just use a single comparable for the time being.
  • Value indicator: Based on the financial information we have on Mars, the only available value indicator is sales. 
  • Valuation Multiple: In 2015, Kraft’s total sales were $54 billion.  Moreover the firm’s enterprise value was approximately $100 billion (debt plus equity), according to Google Finance. These numbers allow us to compute Kraft’s Enterprise-value-to-Sales multiple: 100/54 = 1.85. In words, for each dollar of sales, the market was willing to pay $1.85 in value.
  • Now we can apply this multiple to Mars’ sales of $30 billion to get an estimate of the firm’s enterprise value:
     
    Enterprise ValueMars = SalesMars × Valuation multiple = 30 × 1.85 = 55.5. 
     
    Assuming the market is willing to pay the same multiple as for Kraft, the estimated enterprise value of Mars is $55.5 billion.

 

Relative valuation is easy to use and requires very little data.  In the above example, all we needed to know was the amount of sales Mars achieved in the previous year (value indicator) as well as the typical relation between sales and value for firms that operate in the same industry (valuation multiple). Therefore, two numbers suffice to conduct a valuation.

 

Relative valuation is also very flexible. For example, we can easily adjust it to value firms with operations in more than one industry. To do so, we select the relevant valuation multiple in each industry and conduct a separate valuation for each of the firm’s segments. The sum of the segment values can then be used as an estimate of the overall value of the company.

 

Because it is easy to use and flexibility, it is not surprising that relative valuation is very popular among financial analysts. Still, there are some pitfalls that should be avoided to implement the valuation method successfully.  In particular with respect to the following questions: 

 

  • What do we want to value? 
  • Which are the relevant comparable companies? 
  • Which is the “correct” value indicator? 
  • What is the comparable valuation situation?
  • How accurate is the method?

 

These topics will be discussed in detail in the following sections.