Understanding Financial Multiples: Types and How to Calculate Them

What Is a Multiple?

A multiple is a crucial tool for evaluating a company's valuation and financial health. By dividing one financial metric by another, investors can assess if a company is relatively underpriced or overpriced in its industry. Understanding different types of multiples, such as price-to-earnings (P/E) and EV-to-EBITDA, helps investors make informed comparisons and investment decisions.

How to Calculate Multiples: Formula and Examples

The formula for calculating multiples is:

$\begin{aligned}&\text{Multiple}=\frac{\text{Performance Metric ``A''}}{\text{Performance Metric ``B''}}\end{aligned}$​Multiple=Performance Metric “B”Performance Metric “A”​​

To calculate the multiple, divide the first metric by the second metric. Keep in mind that the metric in the numerator is typically larger than the one in the denominator.

Basics of Understanding Financial Multiples

Metrics are quantitative tools that measure a company's performance. These metrics are used by different people for various reasons. For instance, company executives use metrics to analyze corporate finance and operational strategies. Similarly, analysts can use metrics to make opinions and investment recommendations while investment professionals use metrics to make important decisions about their investing portfolios.

Metrics can be used together to measure a company's financial health and well-being. When grouped together, these metrics are called multiples. As noted above, when one metric is divided by another, it results in a multiple. This figure can be used to make different determinations.

For instance, investors and analysts generally rely on two major methods when they make stock valuations, One is based on cash flow, while the other is based on a multiple of some performance measure, such as earnings or sales.

• Valuation based on cash flow, such as the discounted cash flow analysis, is considered to be an intrinsic valuation
• Valuation based on a multiple is considered to be relative because the multiple is relative to some performance measure

The multiples approach to valuation is a theory based on the concept that similar assets should sell for similar prices.

Different Types of Financial Multiples

Price-to-Earnings (P/E) Multiple

The most common multiple used in the valuation of stocks is the P/E multiple. It is used to compare a company's market value (price) with its earnings. A company with a price or market value that is high compared to its level of earnings has a high P/E multiple. A company with a low price compared to its level of earnings has a low P/E multiple.

A P/E of five times (5x) means a company’s stock is trading at a multiple of five times its earnings. A P/E of 10 times (10x) means a company is trading at a multiple that is equal to 10 times earnings. A company with a high P/E is considered to be overvalued. Likewise, a company with a low P/E is considered to be undervalued.

EV/EBITDA Multiple

EV is a popular performance metric used to calculate different types of multiples. EV shows how much money would be needed to buy a specific company. The EV of a company is calculated by taking the company's market capitalization, adding total debt, including long-term and short-term debt, and subtracting all cash and cash equivalents.

Investors often prefer EV over market capitalization for a fuller valuation picture.

A widely used multiple is the EV to earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple, also referred to as EV/EBITDA. This multiple helps investors compare companies in the same industry or sector before making an investment decision.

EV/EBIT Multiple

The EV to earnings before interest and taxes (EBIT) multiple, also referred to as EV/EBIT, is similar to the P/E multiple, but is preferred by some analysts for its ability to give a more complete picture of a company's financial performance and actual worth.

This multiple helps identify undervalued or overvalued companies and suits less capital-intensive firms with lower depreciation.

EV/Sales Multiple

The EV to sales or the EV/sales sales multiple compares a company's enterprise value to its annual sales. This multiple is vital as it considers a company's equity and debt, providing a sales-based valuation metric.

It's also useful in evaluating companies with negative earnings. Investors should compare a company's EV/sales multiple with others in the same industry for effectiveness.

Practical Example: Understanding a Financial Multiple

A multiple reflects what investors will pay per dollar of earnings, as shown by the P/E ratio. Let's assume that you are analyzing a stock with $2 of earnings per share (EPS), which is trading at $20. This stock has a P/E of 10. This means investors are willing to pay a multiple of 10 times the current EPS for the stock.

The Bottom Line

Multiples are vital tools in evaluating a company's financial health, growth, efficiency, and performance. Commonly used multiples include price-to-earnings (P/E) and enterprise value-to-sales (EV/sales), providing insights into a company's valuation and market standing.

Investors and analysts should use a range of multiples for a comprehensive analysis, avoiding reliance on a single metric. This holistic approach aids in making informed investment decisions by comparing performance measures across similar companies.