Valuation Multiples Fundamentals
Understand what valuation multiples are, why they work, their advantages over DCF, and the critical importance of selecting appropriate peer companies.
Learning Objectives
- Explain what valuation multiples are and why they're useful
- Understand the relationship between multiples and DCF
- Identify when multiples work well and when they don't
- Learn the importance of peer selection in relative valuation
Valuation Multiples Fundamentals#
Imagine you're buying a house. You could hire an appraiser to calculate the present value of all future "housing services" the property will provide—a theoretically correct but impractical approach. Or you could look at what similar houses in the neighborhood sold for recently.
The second approach is relative valuation, and it's how most investors actually make decisions.
The Core Idea: Instead of calculating intrinsic value from scratch (DCF), multiples ask: "What are investors paying for similar companies, and is this company comparable?"
What Are Valuation Multiples?#
A multiple is simply a ratio of price to some fundamental measure:
Multiple = Price / Fundamental
Common multiples include:
| Multiple | Formula | What It Measures |
|---|---|---|
| P/E | Price / Earnings Per Share | Price per dollar of earnings |
| EV/EBITDA | Enterprise Value / EBITDA | Value per dollar of operating cash proxy |
| P/S | Price / Sales Per Share | Price per dollar of revenue |
| P/B | Price / Book Value Per Share | Price per dollar of accounting equity |
| EV/Revenue | Enterprise Value / Revenue | Enterprise value per dollar of sales |
Price vs. Enterprise Value Multiples#
A critical distinction:
| Base | Includes | Use With |
|---|---|---|
| Price (P) | Only equity value | Earnings, Book Value (equity metrics) |
| Enterprise Value (EV) | Equity + Debt - Cash | Revenue, EBITDA, EBIT (pre-financing metrics) |
Why does this matter? Metrics like EBITDA are available to both debt and equity holders, so the numerator should be Enterprise Value (total firm value), not just market cap.
A Common Mistake
Using P/EBITDA is technically incorrect because EBITDA belongs to all capital providers, not just equity holders. Use EV/EBITDA instead.
Why Multiples Work#
1. They Embody DCF Implicitly#
Consider the P/E ratio. If a company has:
- Constant earnings that grow at rate g
- A discount rate of r
- And pays out all earnings as dividends
Then the theoretical P/E equals:
P/E = 1 / (r - g)
A company with r = 10% and g = 3% should trade at P/E = 14.3x. Multiples are shortcuts to DCF, not alternatives to it.
2. They're Market-Based#
Multiples reflect what investors are actually paying—real transactions, not theoretical models. This incorporates:
- Current market risk appetite
- Sector sentiment
- Information the market has but you might not
3. They're Simple and Fast#
A DCF takes hours; comparing P/E ratios takes minutes. For screening hundreds of stocks, multiples are practical.
When Multiples Work Well#
| Situation | Why Multiples Excel |
|---|---|
| Mature, profitable companies | Stable earnings make comparison meaningful |
| Many comparable peers | Better benchmarks available |
| Efficient markets | Peers are fairly valued on average |
| Quick screening | Identify obviously cheap/expensive stocks |
| M&A valuation | What acquirers actually pay |
When Multiples Fail#
1. The Garbage-In Problem#
If comparable companies are all overvalued (think 1999 tech bubble), your target will look "fairly priced" at a P/E of 100x.
Example: In 1999, paying 80x earnings for a dotcom seemed "cheap" because peers traded at 120x. Two years later, most were bankrupt.
2. No True Comparables#
Netflix's early years: Was it a tech company (high P/E)? A media company (moderate P/E)? A retail company (low P/E)? The answer dramatically affected perceived valuation.
3. Different Accounting or Economics#
| Factor | Problem |
|---|---|
| Different depreciation policies | Same EBITDA, different economic reality |
| Different tax rates | Same pre-tax income, different earnings |
| Different capital structures | EV multiples help, but leverage affects risk |
| Different business models | Subscription vs. one-time sales |
| Different growth profiles | 5% grower vs. 25% grower |
4. Negative Denominators#
If a company has negative earnings, P/E is meaningless. This is why unprofitable companies use P/S or EV/Revenue.
The Art of Peer Selection#
The most important—and most subjective—part of relative valuation is choosing comparable companies.
What Makes a Good Comparable?#
| Factor | Ideal Comparable |
|---|---|
| Business model | Same revenue sources, customer type |
| Size | Similar revenue/market cap range |
| Growth profile | Similar historical and expected growth |
| Profitability | Similar margins |
| Geography | Same markets, similar regulations |
| Capital intensity | Similar CapEx requirements |
Building a Peer Group: Example#
Company: CloudFlow (Mid-market SaaS for HR)
| Potential Peer | Include? | Reasoning |
|---|---|---|
| Workday | Maybe | Similar product, but much larger |
| Salesforce | No | Different product (CRM vs HR) |
| Paylocity | Yes | Same market, similar size |
| Paycom | Yes | Same market, similar model |
| UKG | No | Private company (no market data) |
| SAP | No | Much larger, different customer base |
Final peer set: Paylocity, Paycom, Paychex, Ceridian (all HR/payroll focused, similar size/growth)
Peer Selection Rules
- Start with industry classification (GICS codes)
- Filter by size (0.5x to 2x revenue)
- Filter by growth (within 10 percentage points)
- Verify business model similarity
- Aim for 4-8 companies (enough for statistics, few enough to know well)
Interpreting Multiples#
A multiple alone is meaningless. Context matters:
Historical Comparison#
How does today's multiple compare to the company's historical range?
| Period | Company P/E | Market P/E | Relative P/E |
|---|---|---|---|
| 2020 | 25x | 20x | 1.25x |
| 2021 | 35x | 25x | 1.40x |
| 2022 | 18x | 17x | 1.06x |
| 2023 | 22x | 19x | 1.16x |
| Current | 30x | 21x | 1.43x |
Current relative P/E (1.43x) is at the high end—either the company deserves a premium, or it's expensive.
Peer Comparison#
| Company | P/E | Growth | P/E / Growth |
|---|---|---|---|
| CloudFlow | 30x | 20% | 1.5x |
| Paylocity | 35x | 25% | 1.4x |
| Paycom | 28x | 15% | 1.9x |
| Paychex | 25x | 8% | 3.1x |
CloudFlow's 30x P/E looks high, but adjusted for growth (1.5x), it's in line with Paylocity and cheaper than Paycom or Paychex.
From Multiple to Target Price#
To use multiples for valuation:
Target Price = Chosen Multiple × Company's Fundamental
Example:
- Peer group average EV/EBITDA: 12x
- CloudFlow EBITDA: $100M
- Target EV: 12x × $100M = $1,200M
- Minus net debt: -$50M
- Equity Value: $1,150M
- Shares: 50M
- Target Price: $23/share
If the stock trades at $18, it may be undervalued. If it trades at $30, it may be overvalued—unless CloudFlow deserves a premium.
Key Takeaways
- Multiples are ratios of price to fundamentals (P/E, EV/EBITDA, P/S)
- Use P/ multiples with equity metrics; use EV/ multiples with enterprise metrics
- Multiples implicitly reflect DCF assumptions—they're shortcuts, not alternatives
- They work best for mature, profitable companies with true comparables
- They fail when peers are mispriced or no true comparables exist
- Peer selection is the most critical (and subjective) step
- Compare multiples across history, peers, and growth-adjusted bases
- A multiple is just data—interpretation requires understanding the business