Trading Multiple Definition

A trading multiple is a financial metric used to value a company. It is used as part of comparable analysis. The metric of a group of different companies within a sector is compared and analyzed, and allows investors to see which is the most under/overvalued or for the sell-side to attempt to value a firm coming up for an IPO.

Typically, investors will look for companies which they believe are undervalued by the market. The only numbers available straightaway are the share price, number of shares outstanding and market capitalization, none of which are very useful on their own for determining value. Is Ford at $9 a share valued more accurately than Chevron at $109? The numbers bear no relation to each other. The way around this is to look at relative value, which is done through trading multiples.

Investors know that Ford has EPS $4.75 of while Chevron has EPS of $13. This means Chevron is making more money, but that doesn't necessary mean it is better value. Investors will calculate how much they are willing to pay for each dollar of earnings, which is called the price to earnings (P/E) ratio and is one of the most often used valuation methods. In this case, Ford has a P/E of 1.89x while Chevron's is 8.4x. This creates a vastly different picture. To get 1 dollar of profits from Ford you need to invest $1.89 whereas to get that same dollar with Chevron, you would need to put in $8.40.

This concept can be applied to many different financial metrics and the most common of which are:

  • Price To Earnings
  • Price to Book Value
  • Return on Equity

There are a few key things to watch out for when creating and analysing multiples. The most important is that these multiples can only be used with companies in the same industry and preferably of a similar size. For example, while Ford has a P/E of 1.89x, Google's is 18.8x. Does this mean Ford is better value? Perhaps, but you cannot deduce that as tech companies tend to always have a high P/E ratio than manufacturing companies. You can only really compare Ford with Chevron and Google with say Apple or Microsoft. The kind of metrics used will also vary greatly by industry. For example, in O&G or Mining companies you might use Enterprise Value / Proven Reserves, but obviously you cannot use this for a tech company.

The other point to watch is when choosing which metrics to use. They must look at the same kinds of numbers. For example, although you can use EV / EBITDA and this is a very common multiple, you could not substitute Enterprise Value for Market Cap, even though both are measures of a company's overall value. The reason for this is that both EV and EBITDA take into account debt and other non-immediate cash items whereas market cap does not. There are all sorts of slight rules governing this but the main trading multiples usually do a good enough job and there isn't much of a need to go around trying to create your own.

*** All share prices and EPS values were taken from Google Finance as of the close of 27th July 2012 and may no longer be correct at the time of reading, although the mathematics behind it will always apply ***

To learn more about this concept and become a master at valuation modeling, you should check out our Valuation Modeling Course. Learn more here.

Module 1: Introduction

Module 2: Valuation: The Big Picture

Module 3: Enterprise Value & Equity Value Practice

Module 4: Trading Comparables Introduction

Module 5: Trading Comps: The Setup

Module 6: Trading Comps: Spreading Nike (NKE)

Module 7: Trading Comps: Spreading Adidas (ADS.DE)

Module 8: Trading Comps: Spreading Lululemon (LULU)

Module 9: Trading Comps: Spreading Under Armour (UA)

Module 10: Trading Comps: Benchmarking and Outputs

Module 11: Precedent Transactions: Introduction

Module 12: Precedents: The Setup

Module 13: Spreading Tiffany & LVMH

Module 14: Spreading FitBit & Google

Module 15: Spreading Reebok & Adidas

Module 16: Spreading Jimmy Choo & Michael Kors

Module 17: Spreading Dickies & VF

Module 18: Valuation Wrap-Up

Module 19: Bonus: Non-GAAP Practice

Learn More Here

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