Valuation methods: Valuation multiples

Next we will look at different valuation methods, their strengths and the problems associated with them. The aim of this post is to give an overview of valuation methods but also to provide additional sources for those who want to go deeper into the subject. There is plenty of material from around the world, there are many perspectives and there is always more to learn, but for those who read this, reading equity research reports should be easy. 

We start with valuation multiples, which are the most used or at least most commonly communicated valuation methods. In this post, we discuss both absolute valuation multiples and relative valuation, where company valuation multiples are examined in the framework provided by a peer group.

Valuation multiples

Valuation multiples are the most commonly used valuation methods by investors. They are simple and, if applied correctly, can quickly give a reasonable idea of valuation. The best known, but not necessarily the best, valuation multiple is the P/E (Price to Earnings). The multiple relates the market capitalization of the company to its net earnings but the same thing is more easily expressed with share price and earnings per share (EPS). The P/E ratio describes how many times the market capitalization is relative to the company’s earnings. If we assume that earnings remain constant, the P/E ratio also tells us how many years it would take for the company's earnings to pay back its market capitalization.

Valution Multibles 1

The main valuation ratios in addition to the P/E are: EV/EBIT, EV/EBITDA, EV/S, P/B and P/FCF. The EV-based multiples utilize the Enterprise Value (EV), which takes into account net debt, as a benchmark instead of the market capitalization. This gives a better picture for valuation, as the debts are the responsibility of the company and those creditors' interests come before the shareholders. Most of the valuation multiples are calculated on the basis of the profit and loss account, but the the P/B ratio is balance sheet based and there are also several cash flow based multiples (such as P/FCF and P/OFC). The list of potentially reasonable multiples is very long, and because of the different variations (e.g. time period and possible adjustments) the list is endless. Therefore, it’s always a good idea for investors to understand what is behind the figures. 

The following table shows the most common valuation factors and their strengths and weaknesses. I have also included "a normal level" for the multiples, which describes the variation in the median level of the Helsinki Stock Exchange over the past decade. This gives investors at least a rough idea of where the multiples normally fall. The differences between companies are again larger, but as you can see, the variation at index level can also be significant.

Valuation Multibles 2

Application of valuation multiples

In general, the acceptable level of valuation multiples is assessed on the basis of the company's own historical valuation and that of peer companies. When looking at absolute multiples, the aim is to outline these against the company's earnings growth and risk profile, through which the investor can determine an acceptable level of valuation for their own expected return. In this way, the valuation multiples adopted should respond to changes in earnings growth outlook. The acceptable level of valuation multiples is also influenced by, among other things, the level of interest rates, which largely determines investors' required returns. We discuss relative valuation in more detail in the next section.

Valuation multiples can be used, for example, on the basis of an already realized result or on the basis of multiples calculated from the earnings forecasts for the following year. On the other hand, conservative investors may calculate multiples using a long-term average (e.g. 10-year average EPS), and often investors also use a "moving" average both forward (e.g. P/E calculated using the next 12 months' earnings forecasts) and backward (P/E calculated using the last 12 months' earnings). In principle, multiples can be applied to any chosen time period.

Valuation Multiples 3

Relying on a single valuation multiple is often misleading, and a reliable valuation requires a broad perspective. Looking at the P/E ratio alone is like valuing a house based on one exterior alone. A serious house buyer will walk around all the exterior walls, check the inside of the house and visit the basement and roof just to be sure. And the importance of the neighborhood, which in the business world could reflect the industry, should never be underestimated. We recommend the same approach for valuation: different multiples can serve as a review of different exteriors, a qualitative fundamental analysis serves as an interior tour of the house, the neighborhood is toured in the domain overview of the analysis and finally the risk analysis additionally surveys the mold in the basement and the durability of the roof.

Lower is better, but everything is relative

In principle, a lower valuation factor is naturally better than a high one, because we want to achieve the best possible return on our investments. The valuation multiples of different companies can be of different sizes, and rightly so, but if you can buy the same company with a P/E of 10x and a P/E of 30x, the choice is clear. Over time, valuation levels can fluctuate widely, even in the absence of material changes in the company's business or fundamental value. Sometimes investors get carried away and pay 30x for the same company they paid 10x for a few years ago when the stock was unpopular. The stock market represents the collective view of investors on the value of a company at any given moment, but these assessments are not always the result of analytical thinking.

Company-specific differences in the correct or acceptable valuation multiples are huge, which is understandable given the huge differences between companies and their future performance prospects and risk profiles. Valuation multiples must therefore be considered in relation to the company's earnings growth prospects and to the significant risk associated with these prospects and the company in general. The further into the future the multiples are based, the greater the forecast risk the investor bears. A realized result is something relatively concrete and demonstrably achievable. No company has such high visibility that we can accurately predict the next five years. Looking ahead, the investor must also assess what the market's accepted valuation level will be in the future. Both earnings forecasts and estimates of the company's future acceptable valuation level can go horribly wrong.

Relative valuation / Peer group

Relative valuation looks at the valuation of an investment in relation to other similar investments that form a peer group of the company. It is usually reasonable to value companies in the same sector in roughly the same way, which is why it is logical to compare the valuation multiples of companies and try to find mispriced stocks through this. 

However, certain valuation differences are justified in principle, given that companies are always different. This is called a "premium" or "discount" compared to the peer group. Reasons for a premium may include a stronger than average earnings growth outlook, gaining market share, perceived quality of the company, better visibility on earnings performance, a lower risk profile or exceptionally strong competitive advantages, and vice versa.

Key valuation multiples vary across sectors and companies

It is natural to price the industry's future winners significantly higher than the industry's expected losers. However, the winners are never entirely clear. The comparison is made using valuation factors relevant to the companies, such as P/E, EV/EBIT and dividend yield (which is not really a valuation multiple). The main valuation multiples vary across sectors and company profiles.

The comparison can be one-dimensional or more complex. Below is a simple example of the peer group used by Inderes in Sampo analysis, which I think gives a good idea of the company's valuation relative to its peers. Sampo's peer group table fits the company's profile, i.e., it is rather boring: the multiples include the P/E ratio, P/B and dividend yield. EV/EBIT and EV/EBITDA multiples are also dropped because these figures do not offer much value for a financial group.

Valuation Multiples 4

Simply comparing valuation multiples is not enough when looking at differences in valuation

As both the difficulty of valuation and the role of relative valuation increase, it is worth trying to be increasingly accurate in comparing investments and positioning the target company correctly among them. The differences between winners and losers are large and changes can be rapid. Merely comparing valuation multiples is no longer enough, as we also need to look more closely at what valuation differences are justified and why. Many factors are difficult to quantify, but the comparisons still attempt to do so. Relevant factors can be, for example, estimated:

- Revenue growth rate
- Profitability (EBIT margin)
- Continuity and sustainability of revenue
- Business predictability (confidence in forecasts)
- Gross margin and profitability potential
- Market size and potential market share

Advantages of relative valuation

Relative valuation usually provides a good frame of reference for a stock. A good peer group also guides the performance of the individual stock in the group, which is why following peers is an important part of an analyst's or investor's job. From a valuation perspective, it is rare that we see sharply different valuation trends across companies in the same sector. 

Relative valuation usually provides a backdrop for valuation, which is important as valuation is generally a challenging task. In the midst of uncertainty, it's nice to have support for your own view of how the market is proven to price similar stocks. If an investor can utilize a good peer group with consensus forecasts, relative valuation is reasonably easy. In general, the relative valuation should also be combined with a longer time period showing the evolution of the average valuation levels of both the company and its peers. 

The overall valuation of the peer group also speaks volumes of investors' expectations of the sector in general. The importance of sector selection in choosing an investment should not be underestimated, as this determines much of the potential return and the risk borne. Another strength of relative valuation is that active monitoring of the sector and peers significantly deepens the company-specific analysis. Knowing the other companies in the industry helps to gain a broader understanding of the industry drivers, the competitive situation, the strength of competitive advantages and the customer base. These all also support the valuation of an individual company. This is another reason why relative valuation is an important part of the investor's toolbox.

Weaknesses of relative valuation

Relative valuation also has significant weaknesses. In my opinion, the main one of these is that investors can outsource their thinking to market forces by relying too much on relative valuation. Within a peer group, some stocks are always cheaper than others, but they are not necessarily cheap. Relative valuation does not take a position on whether the sector or group as a whole is correctly valued. The method always finds something to buy, even in a sector that is in a valuation bubble. In recent years, for example, the EV/S ratios, growth rates and potential profitability of hot technology stocks were compared against each other in the super-hot bull market. Higher valuations could be justified by more expensive "peers", but at the same time the absolute valuation levels and expectations of the group escalated to unrealistic levels. 

There are other challenges to relative valuation. In general, the investor does not have the resources to do an in-depth analysis of the peer group, so the valuation of the peer group is based on consensus forecasts. The challenge then is the reliability of consensus forecasts, possible adjustments and "one-offs", and possibly different accounting standards and their interpretations. Consensus forecasts are also updated with a long delay after major events, possibly leading to the support from the peer group being weak. An investor can end up comparing apples to oranges if the groundwork is not done very carefully.

Another clear weakness is that not even nearly always can you find sensible peers. The main competitors may well be unlisted companies, in which case they do not have a market capitalization and there is usually a significant delay in the availability of earnings figures. You can often get a rough idea of valuations from things like private equity transactions or potential funding rounds, but the dynamics of these are different. Even listed companies can have very different structures, so the support of valuation is by default imperfect. Business models can also vary greatly. Forcing a peer group out of unsuitable peers can lead to serious valuation fallacies. The best of the bad options may then be to determine the relative valuation through the average valuation of the Helsinki Stock Exchange. 

The shortcut offered by relative valuation can lead into dangerous waters anyway. An investor blind to relative valuation could have sold Tesla short five years ago and bought a basket of traditional car manufacturers as a hedge. This mine could have been dismantled by a more detailed analysis of industry trends, but the shortcut offered by the valuation framework provided by the peer group would have led to misery. In general, the peer group can easily be misused. You have to have a balanced group of companies that are similar to the target company in order to assume that the result is balanced.

Application of relative valuation

Relative valuation is a valuable part of a valuer's toolkit, but it must be applied as part of the whole. Relative valuation is a very good way of establishing the right frame of reference for a company. The greater the weight of relative valuation, the more work needs to be done to examine the acceptable level of valuation of the sector and its peers. It is important to have some kind of reference point, otherwise there is also a risk of blindness to absolute multiples and constant "stretching" of them. Investors should examine the company's history and think critically about why future valuations would differ significantly from this. This review should also be done in conjunction with the overall assessment of the sector. If the valuation of a sector is strongly elevated relative to history, the expected return for the sector as a whole may be much lower than normal.