A discounted cash flow valuation (or DCF) is theoretically the soundest approach to value assets or businesses in a financial modeling and analysis exercise.
However, an alternate valuation approach known as market multiples analysis (also known as comparable companies analysis or direct comparison analysis) is widely used in practice, especially to value companies with high growth potential but limited operating track record.
The concept behind the use of market multiples analysis is that similar assets should sell at similar prices.
A company would be an appropriate comparable if it shares a similar risk and growth profile as the company being valued.
In selecting comparable companies, several criteria such as the industry classification, technology, clientele, size, leverage, growth, similarity in financial ratios are applied.
If the company being valued is a multi-business company, several groups of comparables should be selected, each of which corresponds to one of the target company’s principal businesses.
Market multiples analysis are easy to apply and are widely used, but suffer from several serious limitations.
There are five steps in the application of the market multiple approach :
- Identify comparable companies
- Calculate key ratios for comparables
- Average the key ratios
- Apply average ratio to obtain indicative value
- Make a valuation judgement
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