Market multiples are easy to apply and are widely used, but a good financial analyst should be aware that as a financial valuation approach, market multiples analysis also suffers from several serious limitations.
We will examine some of the pros and cons of market multiple analysis, so that financial analysts can make an informed decision on when, or when not, to apply market multiples analysis in their financial modeling and valuation exercises.
Advantages of Market Multiples Analysis
- Common sense approach – similar companies should sell for similar prices.
- Can be used when other approaches like DCF are difficult to apply due to negative and speculative cash flows.
- Marketplace transactions are used.
- Easy to understand and apply; uses easily available current market data eliminating the need for projecting cashflows.
- Widely used in legal cases.
- Used by investment bankers in their financial modeling and analysis of fairness evaluation and opinions.
Disadvantages of Market Multiples Analysis
- Difficult to find companies that are truly comparable – listed companies are typically larger and less risky.
- Each step in valuing using multiples analysis is subjective and provides an opening for manipulation of results. The multiples approach can justify a wide range of values for businesses.
- Builds in errors (overvaluation or undervaluation) that the market might be making in valuing similar businesses.
- Business being valued is typically not an “average” business and has unique growth and risk profiles. Ignoring fundamentals can lead to significant errors in valuation.
- Using the Price to earnings (P/E) ratio ignores the cost of capital, time value of money and is sensitive to the accounting policies adopted.
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