Beyond the Surface: Diving Deeper into the Perils of Multiple-Based Valuations

“The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do.”

- Warren Buffett, 1982 annual letter to shareholders.

4 November 2024

In today's fast-paced investment landscape a growing trend has emerged in relying on simplified multiples-based valuations to price companies, rather than valuing them based on their fundamentals, often leading to costly mistakes.

This practice has been echoed by Aswath Damodaran, a leading valuation expert and professor of finance at the Stern School of Business at New York University, by stating that

“There’s nothing wrong with pricing. But it’s not valuation. Most people don’t value companies. It’s not their job. Instead, they price companies. The biggest mistake in valuation is mistaking pricing for valuation.”

This article highlights the main limitations of multiple-based valuations, the adjustments that are deemed necessary for a meaningful interpretation of their results, and scenarios where such relative valuation practices might be appropriate.

A Fundamental Principle of Investing

Back in 1934, Benjamin Graham and David Dodd introduced the concept of “value investing”. This timeless investment approach simply suggests that investors should buy shares only in companies that have been priorly well-analysed and identified as significantly underpriced by the market, that is, compared to their true, “intrinsic” value.

Though said concept is quite straightforward in theory, its practical implementation is extremely challenging as it requires specialised knowledge, skills, and substantial investment in time and resources.

Specifically, carrying-out a company valuation pre-requisite the estimation of the future cash flows it can produce during its “lifetime”, discounted to present value. This entails, among others, analysis of financial performance, forecasting growth prospects and estimates, analysis of the industry and competition, management assessment, business risks evaluation, scenario probabilities, capital investment requirements, as well as sophisticated financial modelling skills.

Valuing a company is therefore an inherently subjective and complex task. Even seasoned investors like Warren Buffett and Charlie Munger modestly acknowledge that they can estimate intrinsic value only for a selected few companies in specific industries, and even then, always within a range of values.

“Cracking” the Valuation Complexity Equation

Given these complexities, fund managers, investment bankers, and private investors often find it difficult to genuinely adopt a “value investing strategy” and resort to relative valuations as a shortcut. This approach involves estimating the value of companies or assets simply via the pricing of comparable entities having a common variable, such as earnings, cashflows, book value or sales.

Commonly used relative valuations metrics include the Price-to-Earnings (“P/E”) ratio, the Enterprise Value-to-EBITDA (“EV/EBITDA”) multiples, Price Earnings Growth (“PEG”) ratio, and/or dividends yield.

The Allure of Relative Valuations

Some professionals advocate for relative valuations based on the philosophical claim whereby the intrinsic value of an asset is “almost impossible” to estimate, thus the amount the market is willing to pay for comparable assets should be the best possible approximate.

Others contend that relative valuations are superior compared to the “complicated, time-consuming and full of assumptions Discounted Cash Flow alternative”.

There is also the business marketing rationale - admittedly is much easier for professionals to communicate their pitch to clients using a mix of technical jargon and simplified conclusions, say, by suggesting that specific stocks are underpriced by the market due to much lower P/E ratio compared to industry peers.

Furthermore, supporters of relative valuations point out the fact that Enterprise Value-based multiples follow a similar approach with the Discounted Cash Flow method in the sense that both are hugely determined by the drivers of free cash flow, therefore ultimately reflecting the return on invested capital and growth.

Significant Limitations of Multiple-Based Valuations

Despite their popularity, multiple-based valuations have numerous and serious limitations to the extend that their findings cannot be deemed reliable if interpreted in isolation - thus, in my opinion, investment and/or financial decisions should never be made based primarily, let alone solely, on multiples.

The following paragraphs provide a non-exhaustive list of supporting arguments in this respect.

- Earnings-focused multiples

The results from such multiples wrongly suggest that what drives the price of a share are reporting earnings. However, earnings tell us little about value as they exclude,

(a) a charge for cost of capital, and

(b) the incremental investments in working capital and fixed capital that are needed to support a company’s growth.

EBITDA is used, for example, as a measure of corporate cash flow – this practice disregards crucial factors like capital expenditure and asset depreciation and has rightfully drawn criticism from prominent investors such as Seth Klarman and Charlie Munger.

Moreover, while higher earnings multiplied by a constant multiple would typically result in a higher stock price, this simplistic approach overlooks the dynamic nature of multiples, that is, they do fluctuate over time, both within and across peer firms.

For instance, in a recent real-world example we observed a stark range; a peer company traded at a P/E multiple of 15.8, while another was valued at over 313 times its earnings. Some of the firms even reported negative earnings. In this specific case, the eventually opted median multiple of 25.8 simply failed to capture the wide variation among peers, hence the concluded valuation was debatable to say the least.

Furthermore, as with any valuation exercise, the scope should always be forward-looking. For example, should the denominator of a multiple be the EBITDA, then this need to be adjusted using a forecast of profits, rather than applying current or historic profits. Indeed, research by Kim and Ritter (1999) and Lio, Nissim, and Thomas (2002) have proven that forward looking multiples increase predictive accuracy and decrease variance within an industry.

Another important issue is that earnings growth does not necessarily imply shareholders growth. As stated by Benjamin Graham himself,

“Growth ratios are merely a valuation component, not a valuation as such, though provide clues to the amount and timing of cash flows into the business.”

Put simply, growth is beneficial only when each dollar used to finance growth generates over a dollar of long-term market value. Not to mention that many valuation models, such as the Gordon growth model, assume constant growth rates over time which, in practice, may vary significantly thus leading to overvalued or undervalued estimates.

Finally, earnings-based multiples such as Earnings-Per-Share (“EPS”) can easily and materially be distorted by factors such as stock options and by “creative” accounting.

- Price-to-Sales Multiple

An enterprise-value-to-sales multiple imposes an additional important restriction as it assumes similar operating margins on the company’s existing business. For most industries, this restriction becomes overly burdensome.

- Comparing apples with oranges

A common pitfall in relative valuation is comparing dissimilar companies. That is, even though selected peer groups are within the same industry, important adjustments are still necessary to ensure a reliable comparison.

For example, an appropriate peer group sample should comprise of an adequate minimum number of companies of similar size, with similar performance and with similar debt levels. Else, there will be a need for adjustments and assumptions, i.e. the P/E ratio can be artificially impacted by a change in capital structure, even when there is no change in enterprise value.

Some “hall of shame” real-life examples of inappropriate peer group that we have ourselves witnessed are

(i) a Greek private health clinic seeking new investors was valued by its CFO based on a revenue multiple that was derived from US-listed (!) health clinics, and

(ii) similarly, a local Big4 engaged to value a Cypriot hospitality group used earning multiples of (again) US companies due to a perceived lack of comparable local data.

In both above mentioned cases, the capital structure element was also overlooked.

Another example of an obvious adjustment is the need to exclude items with different financial characteristics from the core business, such as non-operational items and excessive cash, and/or one-off items.

Most of the above have been nicely summarised by Warren Buffet during Berkshire Hathaway Annual Meeting of 1992:

“...it will be silly for the would-be purchaser to focus on current earnings when the prospective acquirer has either different prospects, a different mix of operating / non-operative assets, or a different capital structure.”

The period covered by the sample should also exclude “market bubbles” that would otherwise artificially inflate the results and produce misleading conclusions.

Similarly, certain industries are more cyclical than others, meaning their earnings can fluctuate significantly over economic cycles. Using valuation multiples based on recent earnings will again be misleading during periods of economic expansion or contraction, therefore multiples will need to be adjusted and normalised accordingly.

- Misinterpretation of deriving results

In many cases, the ending multiple-based result could be interpreted either way.

For example, a high P/E ratio might signal a promising future of high growth, but simultaneously it could also indicate that the market is overvaluing the company.

Similarly, a low P/E ratio may be perceived as a company being undervalued, or instead that its riskier, and/or its growth prospects are poor, or both.

Elaborating further on the widely talked about P/E ratio, the latter could vary for additional reasons than the above – that is, simply because companies go in and out of fashion (Securities Analysis textbook, Benjamin Graham, David Dodd).

Simply put, when there is a hype about specific stocks, people tend to bid them up very high. When the hype is over, their P/E gets lower.

- Inherent market assumptions and limitations

Finally, a portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts’ judgments are right; effectively it will be less overvalued than other securities in the market.

Also, relative valuation is built on the assumption that markets are correct in the aggregate but make mistakes on individual securities. Thus, to the degree that markets can be over or under valued in the aggregate, relative valuation will, inevitably, fail.

Practical Use and Benefits of Multiples

Nevertheless, valuation multiples can be a useful tool for financial analysis when applied intelligently, consistently and with caution, that is, with awareness as to their limitations.

Savvy valuation experts for example may use multiples of comparable companies to complement the main valuation, say the traditional discounted cash flow (“DCF”) model by comparing its end-result. Any significant variations will give a strong signal for further review and analysis on valuation inputs and assumptions.

Relative valuation could also be very helpful for start-ups, especially at their early days of operation where there is fundamental uncertainty about their future, lack of objective data, untested business environment, intensive use of intangible assets (such as technology, brand, innovative idea) and talented individuals that are extremely difficult and subjective to value, not to mention unstable financials and negative profitability.

Despite the complexity and increased subjectivity, a start-up valuation exercise would be necessary to develop an informed opinion for investors about the target’s expected valuation and as part of the negotiation process, i.e. to justify the founders’ bargaining position.

In such early phase, traditional cash flow valuation models may not produce reliable estimates and hence the simplicity offered by relative valuations may be opted, using operational, non-financial based multiples that will represent a reasonable predictor of future value creation tied to return on capital and growth.

For example, in the case of an internet-based company, the enterprise value could be peer-compared based on website hits, unique visitors, or number of subscribers.

Epilogue

Despite their serious limitations, the misconception and misuse of multiple-based valuations is higher than ever before.

Contrary to their increasing popularity, this article has highlighted the shortcomings of multiple-based valuations and emphasized the importance of considering underlying value drivers.

Although relative valuations can be a useful tool, they must be applied rigorously and always in conjunction with other valuation methods.

Otherwise, costly mistakes may be incurred, echoing the clear warning stated at this article’s epigraph, while also ratifying Oscar Wilde‘s observation of more than a century ago:

“A cynic is a man who knows the price of everything and the value of nothing”.

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Important Disclaimer: This article provides general information only and represents solely the personal opinion of the author with whom some may agree, and others may not. The article is not intended nor should be regarded or perceived in any way as any direct or indirect form of investment advice.

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