What are the advantages and disadvantages of using multiples vs DCF for valuation?

1 What are multiples?

Multiples are ratios that compare the value of a company or asset to a financial metric, such as earnings, revenue, or cash flow. For example, the price-to-earnings (P/E) multiple measures how much investors are willing to pay for each dollar of earnings. Multiples can be derived from the market prices of comparable companies or assets, or from industry norms or benchmarks. Multiples are easy to calculate and understand, and they reflect the current market sentiment and expectations.

2 What are the drawbacks of multiples?

However, multiples also have some limitations and challenges. First, finding truly comparable companies or assets can be difficult, especially for unique or niche businesses. Second, multiples can be affected by accounting differences, such as depreciation methods, inventory valuation, or revenue recognition. Third, multiples do not account for the growth potential, risk profile, or competitive advantage of the company or asset being valued. Fourth, multiples can be influenced by market cycles, trends, and anomalies, which may not reflect the intrinsic value of the company or asset.

3 What is DCF?

DCF is a valuation method that estimates the present value of the future cash flows generated by a company or asset. DCF involves projecting the cash flows over a forecast period, usually based on the expected growth rate, operating margin, and capital expenditure. Then, a terminal value is calculated to capture the value beyond the forecast period, usually based on a perpetual growth rate or an exit multiple. Finally, the cash flows and the terminal value are discounted to the present using a discount rate, which reflects the risk and opportunity cost of investing in the company or asset.

4 What are the benefits of DCF?

DCF has several advantages over multiples. First, DCF is based on the intrinsic value of the company or asset, rather than on the market price or the performance of peers. Second, DCF allows for more flexibility and customization, as it can incorporate different scenarios, assumptions, and sensitivities. Third, DCF can capture the value of intangible assets, such as brand equity, intellectual property, or customer loyalty. Fourth, DCF can account for the time value of money, which means that cash flows received sooner are worth more than cash flows received later.

5 What are the challenges of DCF?

However, DCF also has some drawbacks and difficulties. First, DCF relies heavily on the accuracy and reliability of the cash flow projections, which can be uncertain and subjective. Second, DCF requires choosing an appropriate discount rate , which can be challenging and controversial. Third, DCF can be sensitive to small changes in the inputs, such as the growth rate, the terminal value, or the discount rate, which can result in large variations in the output. Fourth, DCF can be complex and time-consuming to perform and explain, especially for non-financial audiences.

6 How to choose between multiples and DCF?

There is no definitive answer to which valuation method is better or more appropriate. It depends on the context, purpose, and availability of data and information. Multiples are more suitable for quick and simple valuations, or for comparing relative values across a group of similar companies or assets. DCF is more suitable for detailed and comprehensive valuations, or for capturing the unique value drivers and risks of a specific company or asset. Ideally, both methods should be used and compared to get a range of values and to cross-check the assumptions and results.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?