Equity Valuation Using Multiples: An Empirical Investigation

1 Introduction1.1 MotivationEquity valuation is a primary application of finance and accounting theory. Atypical business school curriculum, therefore, devotes substantial time to this topic.The theoretical emphasis usually focuses on discounted cash flow (DCF) and residualincome valuation (RIV) models. These models, however, are often cumbersometo use and sensitive to various assumptions. Consequently, practitioners regularlyrevert to valuations based on multiples, such as the price to earnings (P/E) multiple,as a substitute to more complex valuation techniques (Lie & Lie 2002, p. 44). Thesemultiples are ubiquitous in analysts’ reports and investment bankers’ fairness opinions.They also appear in valuations associated with corporate transactions. 4 Evenadvocates of complex valuation techniques frequently resort to using multipleswhen estimating terminal values or checking their results for plausibility (Bhojraj &Lee 2002, p. 407-408).The primary reason for the popularity of multiples is their simplicity. A multipleis simply the ratio of a market price variable (e.g., stock price) to a particularvalue driver (e.g., earnings) of a firm. Based on how the market values comparablefirms within the same industry or, sometimes, comparable corporate transactions,practitioners can quickly come up with estimations of a target firm’s equity value.As multiples always refer to the market values of comparables, the multiples valuationmethod represents an indirect, market-based valuation approach; it is alsoknown as the method of comparables and usually carried out in four steps.The first two steps involve the selection of value relevant measures, the valuedrivers, and the identification of comparable firms, the peer group. Together withthe market price variables, the value drivers form the basis for the calculation of thecorresponding multiples of the comparables. Step 3 concentrates on the aggregationof these multiples into single numbers through the estimation of synthetic peergroup multiples. Finally, to determine the value of the target firm, the synthetic peer4 E.g., initial public offerings (IPOs), leveraged buyouts (LBOs), management buyouts (MBOs),mergers and acquisitions (M&A), equity carve outs, or spin offs (Achleitner 2002, p. 139-151).