Valuation Multiples
What are valuation multiples?
Valuation multiples are financial tools that help us understand whether the price of a company is fair.
They express how many times we are paying for a given profit—in other words, they tell us how many years it would take the company to generate, with its earnings, the price we paid for it.
On their own, these multiples do not say much. Their real value lies in comparison.
You should always analyze them in relation to:
- Their historical average.
- The market average as a whole.
- The average for their sector or their main competitors.
As investors, we will always be interested in buying businesses with low multiples, as this indicates high profitability.
However, beware of value traps! A low multiple could mean the business is in decline, not that it is a bargain.
Factors that influence multiples
The value of multiples is not fixed; it depends on several factors that reflect the quality and potential of a business. The most important are:
- Growth: Strong growth in organic sales and earnings per share (EPS) often justifies higher multiples.
- Business quality: Companies with stable sales and solid profit margins are more attractive and therefore command higher multiples.
- Competitive advantages (“Moat”): The barriers that protect a business from competition (such as a strong brand or a patent) increase its value and thus its multiple.
- ROIC (Return on Invested Capital): There is a high correlation between a high ROIC and a company’s valuation.
- Financial health: A strong balance sheet with net cash indicates greater solidity, which can raise multiples.
- Sector and country: The economic and regulatory context of the sector and country where the company operates directly influences its valuation.
- Hype: Fads or bubbles in the market can inflate multiples artificially.
How to use valuation multiples?
To invest using valuation multiples, the strategy is simple: look to buy shares at a low multiple relative to their historical average, the market as a whole, or key competitors in their sector.
Once you identify an opportunity, you can earn a return in three ways:
- Multiple expansion
- Growth in the company’s earnings
- Multiple expansion and earnings growth
- This is the best combination, as earnings growth is multiplied by multiple expansion, generating a higher return.
What affects valuation?
- Earnings announcements are key. If a company fails to meet analysts’ expectations, the market will punish it.
- Sometimes the market can “overreact” to mediocre results, which can present an excellent long-term buying opportunity.
- Conversely, a share price can also rise significantly if the company beats market expectations.
Main valuation multiples/ratios
Enterprise Value (EV)
The most common ratios are based on Enterprise Value (EV), which is calculated as the market value of the shares (Market Cap) plus net financial debt.
Main valuation ratios
According to the study by “Morgan Stanley Dean Witter Research”, the main valuation ratios, ranked by their use among analysts, are:
- P/E
- EV/EBITDA
- EV/FCF
- EV/EBIT
P/E (Price-to-Earnings Ratio)
The P/E (Price-to-Earnings), also known as P/E ratio, is without doubt the most famous and widely used ratio among individual investors. It is easy to find and calculate, as it relates the share price to earnings per share (EPS).
Why is it useful?
It is the workhorse of valuation—quick, simple and should always be part of your analysis. It gives us an immediate idea of how much the market is paying for each euro of net profit.
When to use it?
Although very popular, it has a key limitation: it does not consider the company’s debt. This can favour highly leveraged companies or, conversely, make it harder to analyze companies with a lot of cash.
So if you want to be more conservative, it is better to use a ratio that includes debt, such as EV/Net Income.
What is the average value?
The market typically trades at an average P/E of around 16x, but high-quality companies with strong growth prospects can trade at a much higher P/E.
Calculation formulas
The P/E can be calculated in several ways:
EV/EBITDA
This is one of the most popular ratios among professionals, especially in mergers and acquisitions. It relates the total value of the company (EV) to its operating profit before interest, taxes, depreciation and amortization (EBITDA).
Why is it useful?
It is excellent for comparing companies of different sizes and countries, since EBITDA excludes the effects of depreciation (which can vary with accounting policies), taxes and debt. That is why it is the preferred ratio for private equity funds.
When to use it?
It is very useful for companies with light capital structures (without many assets) where EBITDA converts efficiently into free cash flow. However, it is not suitable for capital-intensive companies (such as industrials or logistics), since EBITDA does not take into account the high CAPEX needed to maintain and renew their assets.
What is the average value?
The market trades at an average EV/EBITDA of around 10x, but this varies enormously by sector.
EV/FCF
This is the most complete and conservative valuation ratio. It relates the value of the company (EV) to the Free Cash Flow (FCF) it generates.
FCF is the real money the company has left after all its obligations and the capital expenditure needed to operate.
Why is it the best?
FCF is very hard to manipulate in accounting terms, which makes this multiple the most reliable. It shows you how much you are paying for the real, pure cash the company generates. If FCF increases, the value of the company does too.
When to use it?
This should be your main ratio for making the final investment decision. Although it is more complex to calculate, it offers the most accurate view of a company’s financial health.
What is the average value?
The market average is around 16x–17x, but again this can vary significantly.
EV/EBIT
The main difference from EBITDA is that EBIT does include depreciation and amortization (D&A).
Why is it useful?
By including D&A, EBIT gives us a more complete picture of operating profitability than EBITDA, since the wear and tear on assets is a real cost for the business.
When to use it?
Although less common than EV/EBITDA, it is still useful for comparisons. However, if you are already using other ratios such as EV/EBITDA, P/E and EV/FCF, this one may be dispensable.
What is the average value?
The market average typically ranges around 12x, but as always, higher-quality companies within an industry tend to trade at a higher multiple.