"A key benefit of Relative Valuation analysis is that the methodology is based on the current market stock price. The current stock price is generally viewed as one of the best valuation metrics because markets are considered somewhat efficient. But applying multiples is not a straight forward technique and many considerations have to be kept in mind when valuing a company. Sanity check is advised by using other valuation methods as well."
Advantages of Using Relative Multiples
- Usefulness: Valuation is about judgment, and multiples provide a framework for making value judgments. When used properly, multiples are robust tools that can provide useful information about how similar assets are placed in the market.
- Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user-friendly method of assessing value.
- Relevance: Multiples focus on the key statistics that other investors use. Since investors in aggregate move markets, the most commonly used statistics and multiples will have the most impact. These factors, and the existence of wide-ranging comparables, help explain the enduring use of multiples by investors despite the rise of other methods. Most Valuation in stock markets are done through this method.
Disadvantages of Using Relative Multiples
- Simplistic: A multiple has a great deal of information into a single number. By combining many value drivers into a point estimate, multiples may make it difficult to disaggregate the effect of different drivers, such as growth, on value. The danger is that this encourages simplistic – and possibly erroneous – interpretation.
- Static: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture the dynamic and ever-evolving nature of business and competition.
- Difficult to compare: Multiples are primarily used to make comparisons of relative value. But comparing multiples always challenging, because there are so many reasons that multiples can differ, not all of which relate to true differences in value. For example, different accounting policies can result in diverging multiples for otherwise identical operating businesses.