Valuation Multiples Explained

Think about walking into a market to buy vegetables. You wouldn’t just pick any vegetable and hope it’s priced fairly. Instead, you’d compare prices across different stalls, taking into account quality, freshness, and size. Similarly, in the world of company valuations, valuation multiples allow investors to compare companies and determine if they’re fairly priced relative to others in the same industry.

What Are Valuation Multiples?

Valuation multiples are ratios used to compare a company’s value against its key financial metrics (like earnings, revenue, or assets). They give investors a way to assess whether a company is undervalued or overvalued by comparing it to similar companies or industry averages.

For example, if you were comparing two grocery stores in your area, you might use a price-per-kilo comparison to see if one is priced higher than the other, given that both stores sell the same quality of vegetables. Similarly, in finance, investors use multiples like **Price-to-Earnings (P/E) **or Enterprise Value-to-EBITDA (EV/EBITDA) to gauge the value of a business.

Commonly Used Valuation Multiples:

1. Price-to-Earnings (P/E) Ratio

The P/E ratio compares the company’s share price to its earnings per share (EPS). It tells you how much investors are willing to pay for each ₹1 of the company’s earnings.

Formula: P/E = Market Price Per Share / Earnings Per Share (EPS)

Example: If a company’s share price is ₹100 and its earnings per share is ₹5, the P/E ratio is:

P/E Ratio = ₹100 / ₹5
P/E Ratio = 20

This means investors are willing to pay 20 times the company’s earnings for each share.

2. Enterprise Value-to-EBITDA (EV/EBITDA)

The EV/EBITDA ratio compares the company's enterprise value (EV) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It helps assess how much investors are paying for a company’s earnings power, excluding capital structure.

Formula: EV/EBITDA = Enterprise Value (EV) / EBITDA

Example: If a company’s enterprise value is ₹1,00,000 crore and its EBITDA is ₹10,000 crore, the EV/EBITDA ratio is:

EV/EBITDA ratio = ₹1,00,000 crore / ₹10,000 crore
EV/EBITDA ratio = 10

This means investors are paying ₹10 for every ₹1 of earnings before interest, tax, depreciation, and amortization.

3. Price-to-Book (P/B) Ratio

The P/B ratio compares the market value of a company’s stock to its book value (net asset value). It helps investors assess whether a company’s stock is trading at a premium or discount to its book value.

Formula: P/B Ratio = Market Price Per Share / Book Value Per Share

Example: If a company’s share price is ₹50 and its book value per share is ₹25, the P/B ratio is:

P/B Ratio = ₹50 / ₹25
P/B Ratio = 2

This means the company is trading at twice its book value.

4. Price-to-Sales (P/S) Ratio

The P/S ratio compares a company’s market capitalization to its revenue. It’s a useful metric for companies with low or negative earnings, as it shows how much investors are willing to pay for each unit of revenue.

Formula: P/S Ratio = Market Capitalization / Revenue

Example: If a company’s market capitalization is ₹10,000 crore and its revenue is ₹2,000 crore, the P/S ratio is:

P/S Ratio = ₹10,000 crore / ₹2,000 crore P/S Ratio = 5

This means the company is valued at 5 times its annual revenue.

Why Are Valuation Multiples Important?

1. Quick Comparisons: Multiples allow investors to quickly compare a company’s value to that of its peers, without needing to delve into complex valuation models like DCF.
   

2. Industry Benchmarks: They help investors gauge whether a stock is overvalued or undervalued relative to others in the same industry.
   

3. Used in M&A and IPOs: Multiples are often used in mergers and acquisitions to evaluate the relative value of companies in a sector. They are also helpful during initial public offerings (IPOs) to set a fair share price.
   

Limitations of Valuation Multiples:

• No Industry Universality: Different industries can have different benchmarks for multiples. A high P/E in one industry may be considered normal, while the same number in another industry might signal overvaluation.
  

• Over-Simplification: Relying solely on multiples may overlook important company-specific factors, such as management quality or future growth potential.
  

• Market Conditions: Multiples are influenced by market sentiment, so during market extremes, they may not accurately reflect the company’s intrinsic value.
  

Valuation multiples are widely used to assess companies in sectors like IT (e.g., Infosys, TCS), consumer goods (e.g., HUL, Maruti Suzuki), and banking (e.g., ICICI Bank, HDFC Bank). Investors often compare these multiples to the industry averages to determine if the stock is fairly valued.

Valuation multiples are essential tools for investors, giving a quick snapshot of how a company compares to its peers. They help assess whether a company is under or overvalued and are particularly useful in M&A, IPOs, or comparing similar companies. In the next chapter, we’ll explore Dividend Discount Model (DDM) in more detail and its role in valuation for dividend-paying companies.