Trading Multiples

When Einstein came up with the theory of relativity, he concluded that the rate at which time passes depends on your time of reference.

Relativity is present in the financial markets as well. The data like stock's price or market capitalization doesn't tell us much without a frame of reference. That is why analysts came up with the concept of trading multiples. Read on to learn what they are and how to use them in your analysis.

What are Trading Multiples?

Trading multiples are financial metrics for a company's valuation. They show how the market perceives a particular stock in comparison to a similar one.

Under the assumption that the markets are efficient, the discrepancy in trading multiples between similar companies shows the premium the market is willing to pay. Ultimately it is about expecting more value down the road.

While there are many multiples out there, most of them combine some function of price or revenue to create a usable ratio.

Here are some of the most popular ones:

• P/E: Price-to-earnings ratio is one of the most common multiples. It compares the price of a stock with earnings per share. Historical averages are from 12 times to 30 times. Currently, the S&P 500 P/E average is 34.37.
• PEG: Price-to-earnings growth ratio is the P/E ratio divided by earnings per share growth rate. It goes a step forward, adding the growth into the calculation. Multiples are usually between 0.5 times to 3.5 times.
• Price/book ratio: This shows the proportion of share price to the company’s book value (dividend per share). It is a good ratio for companies where assets primarily drive the earnings.
• Price/sales: Proportion of share price to revenue per share. Useful for companies that operate on a loss.
• Dividend yield: Dividend per share divided by share price. Suitable for yield comparisons in the same sector company’s book value and traditionally an important ratio for yield investors.
• Debt/equity ratio (D/E): Measuring total liabilities against shareholder equity. It shows how much leverage a company is using. While higher leverage equals higher risk, there is no optimal amount of leverage as it varies between sectors.

While the ratios above are the most popular ones for retail investors, analysts working on large deals need to look at the larger picture. So, they use these multiples to get the bird's eye view.

• Enterprise value (EV)/EBITDA: A common multiple that compares the enterprise value with earnings before interest, taxes, depreciation and amortization. Usually in the range of 6 times to 15 times. Some sectors like transport or hospitality use EBITDAR, adding rental costs into the equation.
  • EV = market capitalization + debt + preferred stock + minority interest – cash
• EV/revenue: A valuable ratio for startups and young companies that often have negative EBITDA and cannot use the 1st multiple. Usually, it is in the range of 1 time to 3 times.
• EV/EBIT: Useful for noncapital-intensive operations, like tech companies where depreciation and amortization are not significant factors. The usual range is 10 times to 20 times.
• EV/invested capital: Useful for capital-intensive industries

How to Identify Comparable Businesses

The activity of comparing the company's valuation multiples to those of its peers is called comparable company analysis, or in short, “comps.”

Comps are straightforward to use and the data is easy to obtain (for publicly-traded enterprises). Furthermore, assuming the market efficiency, comps provide a reasonable valuation range.

Pros of comps include their ease to calculate, explain and have established benchmarks.

Their cons, on the other hand, are that they are sometimes influenced by temporary market conditions, less reliable for illiquid companies and not practical if there are few companies to compare.

The 1st step in comps is to identify the criteria for the company's comparison. Naturally, the company has to be the most similar to the company you are trying to value.

Thus, a list for initial screening should look like this:

• Industry classification: The most obvious comparison filter. Professionals use tools like The Bloomberg Industry Classification Standards (BICS), while you can simply look at the products and services of companies you want to compare.
• Size: This includes market cap, number of employees, revenue and other factors.
• Geography: Comparison by regions of operation is important as it considers numerous factors like consumer demographics, culture, laws and regulations and geopolitical risks.
• Growth rate: Needless to say, the growth rate is one of the hottest keywords in recent times. Investors keep an eye on it because a higher growth rate mandates higher valuation by discontinuing the future cash flow.
• Profitability: Similar to the growth rate, profitability significantly influences the valuation as the company with the higher margins will fare better. Better margins transfer into greater profits and thus more investment in growth or higher dividends.
• Capital structure: Debt is a short but menacing word. The more debt a company has, the greater the risk shareholders carry, as its claims come after the debt holders. Thus, higher debt typically transfers into a valuation discount.

Using Trading Multiples to Invest in the Stock Market

Multiples are valuable because they represent a tangible filter for stock selection. While they are most useful for sector comparisons, they can be a trigger for some investors.

For example, a value investor might screen for all the stocks with a P/E ratio lower than 14 and then filter further.

Alternatively, a thematic investor might go after only 1 sector but look for the best deal in that sector.

For example, a reversal in the interest rate policy that is bound to (eventually) happen should positively impact the banking industry.

Examine the data on the top U.S. banks:

• JPMorgan Chase & Co. – P/E 10.20
• Bank of America Corp.  – P/E 12.93
• Wells Fargo & Co. – P/E 13.36
• Citigroup Inc. – P/E 6.92
• U.S. Bancorp – P/E 12.10

An example that stands out is Citigroup that is notably cheaper than its peers. This fact alone isn't enough to proclaim that the stock is the best buy out of the group, but it is a starting point for the research.

• Is the market underestimating the stock?
• Will it outperform its peers significantly when the fundamentals change?

These are the questions that a savvy investor will investigate further. The multiplier was not the means to an end but a simple idea catalyst.

Investment research doesn’t have to be time-consuming. Proper tools can save you hours, avoiding complicated calculations with just a few clicks.

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Filtering the Noise

It is no secret that, over the decades, the stock market became a very noisy place. With thousands of companies listed and hot IPO prospects hitting the market almost every month, it is tough to cut through that jungle.

This is where valuation multiples come in handy, offering quantifiable values to filter out the outliers and perceive opportunities.

Yet, they do come with 2 caveats. First, they require experience. You have to know what you're looking for and why since not all multiples should be used in every scenario.

Second, they are not an ultimate solution but rather one of the 1st steps toward finding a quality investment at a reasonable price.

Frequently Asked Questions