Publication number: ELQ-54612-1
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How to Use Trading Multiples for Valuing a Company.
A step-by-step guide on how to use trading multiples for valuing a company.
Introduction
WHAT IS TRADING MULTIPLES?
Trading Multiple Valuations is nothing but identifying comparable companies and performing relative valuations like an expert to find the fair value of the firm.
The trading multiple valuation processes starts with identifying the comparable companies, then selecting the right valuation tools and finally preparing a table that can provide easy inferences about the fair valuation of the industry and the company.
Before digging into the nitty-gritty of trading multiples, first, let’s take a simple trading multiple example to illustrate how it works.
Trading Multiple Example
Let’s say that you’re comparing between two companies – Company Y and Company Z. At this moment, as an investor, you only know the share price, the number of shares outstanding for each company, and the market capitalization.
Comparing the share price of Company Y ($10 per share) and Company Z ($25 per share), you don’t understand anything. How would you tell which company is doing great by just looking at the share price?
That’s why you would look for relative value by using trading multiples.
First, you saw the earnings per share (EPS) of each company. You found out that the EPS of Company Y is $5 per share and EPS of Company Z is $9 per share. By looking at EPS, you come to the conclusion that Company Z is making more money than Company Y. But that doesn’t mean it has any benefit to you.
To find out how much you would get out of the company shares if you would buy them in the first place, you need to look at the price-earnings ratio. By looking at the P/E Ratio, you found out that for Company Y, it’s 1.5 and for Company Z, it’s 6.
Now it becomes clear that which company is more profitable for you as an investor. You would get a dollar worth of earnings by paying $1.50 to Company Y; whereas, you would get a dollar worth of earnings by paying $6 to Company Z. That means Company Y is certainly the more beneficial for you as an investor.
- Step n°1 |
IDENTIFYING COMPARABLE COMPANIES
Below is the comparable company analysis when I analyzed Box IPO.
The first question the investors ask – how would we identify the comparable companies? The question is obvious. Since there are many companies in the industry, how would one know the right companies?
--->First, you need to look for the business mix. Under business mix, you would see three things – products and services offered by the companies, the geographical location of those companies, and the type of customers they serve.
--->Second, you would see the size of the companies. Under the size, you can choose any or all three of determinants – revenues of these companies, total assets under management, and/or EBITDA margins of these companies.
The idea is to find out the right industry, right services/products, and right trading multiples.
Additionally, as we see above in Box IPO comparable company analysis, we have also included Market capitalization and Enterprise Value. The reason we do that is that we do not want to compare a small cap company with a large cap company as their valuation may be different due to different growth paths.
