use of multiples in valuation

I have argued in a previous post that the only way one can value a cash flow generating asset, such as a business, is based on the discounted cash flows method. This is on the premise that value of the business is the present value of its cash flows discounted at an appropriate rate. I have then argued that use of multiples is actually not a valuation; it is rather pricing.

Having said that, multiples can actually play some role in an analyst's affairs. Here's how: If cash flows, growth and risk could be estimated with comfort there is no need for any other analysis; we can just value the stock (i.e. business behind that stock), and then take a decision after checking the price. However, this is not the case usually since valuation is precisely a process of estimation with a lot of discomfort. In such situations the analyst can look for other clues. One such clue is the use of multiples. We can also use implied variables in the market's pricing, such as the growth rate for clues. Another is the dividend yield on the stock.

A stock might appear to be high or low based on equity-based multiples such as price-earnings ratio, price-to-book ratio, or even firm-based multiples such as price-operating-profit, price-to-book, price-to-sales ratio. Obviously, the clue is how the market is pricing the stock or the firm. There are key differences between the equity-based and firm-based multiples which is for another post.

While stocks do trade at high multiples or low multiples for good reasons, frequently stocks trade at wrong multiples too. Naturally then, these multiples help us in checking out the extent of irrationality in the stock price. A good way to use these multiples is to screen the stocks for cash flows based valuation, or to check out the multiples after a valuation has been done. This is to provide some sort of comfort to the valuation process and estimated value of the stock. We can say that the more irrational the prices are, the higher the comfort level in valuation process; any chances of error in valuation is cushioned by the stupidity in market prices.

For instance, Pepsi is currently trading at a PE multiple of 18.05 and has market value of $119 b; and Pfizer is trading at 18.87 with market value of $207 b. The two companies are completely different businesses probably having different cash flows patterns, growth and risks; they also operate in different markets. Then their similar multiples appear to be just a coincidence. Amazon is trading at an astronomical PE multiple and has market value of $161 b. A good way to interpret this would be to first check if they appear to be trading at too-high or too-low multiples for screening purposes only, and then carry out their business valuation, and compare the fundamental multiples, i.e. value-to-earnings with price-to-earnings.

The only way the multiples help us is by telling us that a stock is trading at too-high or too-low multiples. Put another way, if a stock does not appear to be trading too-high or too-low, the multiples do not help us.

Needless to say, though, multiples-based-pricing does not and cannot replace cash flows-based valuation process.

Nevertheless, there is some use of multiples for value analysts. It gives clues to make money out of market's follies.