Equity Valuation Using Multiples: An Empirical Investigation

Introduction 3Fourth, screening on multiples – fundamental screening – allows quick comparisonsbetween firms, industries, and markets. Finally, multiples reflect the current moodof the market, since their attempt is to measure relative and not intrinsic value (Damodaran2001, ch. 8, p. 1-2).By construction, the method of comparables generally leads to valuationsclose to market values. This feature helps investors to get a feeling for the marketvalue of privately held entities (e.g., private firms, subsidiaries, single business unitsof publicly traded firms) from their comparables; it also plays a key role in theprocess of finding appropriate prices or price ranges for corporate transactions(Penman 2004, p. 67-68).On the surface, using multiples seems straightforward. Unfortunately, in practice,it is not as simple as it appears. The selection of value drivers, which are“truly” value relevant, and the identification of a peer group consisting of “truly”comparable firms involve several problems. We must also make choices on how tocalculate single firm multiples and how to estimate synthetic peer group multiples.In fact, practitioners struggle for general guidelines, but capital market researchdoes not provide them with adequate empirical findings. The explanation for whymultiples vary across the peer group and why valuations vary depending on the useof different value drivers constitutes another problem of the multiples valuationmethod (Palepu, Healy & Bernard 2000, ch. 11, p.7).The P/E multiple is the most popular multiple. Analysts and investment bankers,however, do not build their decisions solely on the P/E multiple. Instead, theycalculate a set of five to eight multiples whereof one or two are relevant for decision-making;the other multiples serve for the hedging, the interpretation, and theargumentation of the results (Tasker 1998, p. 2-4). Since the choice of relevant multiplesusually depends on the industry membership of the firm being valued, theyare called industry-preferred multiples. Across industries, practitioners typicallyrefer to “hard” earnings, book value, or cash flow measures for the calculation ofmultiples (Barker 1999a, p. 401). Although several studies find empirical evidencefor the value relevance of “soft” measures such as research and development (R&D)Auken (1990), DeAngelo (1990), Tasker (1998), Barker (1999a and 1999b), Block (1999),Peemöller, Kunowski & Hillers (1999), Bradshaw (2002), or Demirakos, Strong & Walker (2004).