Price and Enterprise Value Multiples in Valuation

There are two methods of using price and enterprise value multiples:

• The method of comparables.
• The method based on forecasted fundamentals.

The Method of Comparables

The method of comparables is the valuation of an asset based on multiples of a similar asset (comparables or guideline assets).

Multiplying a benchmark value of the price-to-earnings (P/E) multiple by an estimate of a company’s earnings per share provides a quick estimate of the value of a company’s stock that can be compared with the stock’s market price.

Also, comparing a stock’s actual price multiple with a relevant benchmark multiple should come up with the same conclusion on a stock’s relative valuation.

The economic rationale behind the method of comparables is the law of one price, i.e., the economic principle that two identical assets should have a similar price.

The Method Based on Forecasted Fundamentals

This method refers to the use of multiples that are derived from forecasted fundamentals rather than comparables with other companies. Fundamentals are characteristics of a business related to profitability, growth, or financial strength.

The justified price multiple is the multiple’s estimated fair value, which can be justified based on the method of forecasted fundamentals or the method of comparables.

The economic rationale underlying the method based on forecasted fundamentals is that the numerator value used in the justified price multiple is derived from the DCF model.

Question

The economic rationale underlying the method of comparables is most likely:

1. The law of one price.
2. The characteristics of a business related to profitability, growth, or financial strength.
3. The justified P/E is higher than the actual P/E.

Solution

The correct answer is A. 

The law of one price is the economic rationale underlying the method of comparables that states that two identical assets should sell at the same price.

B is incorrect. The characteristics of a business related to profitability, growth, or financial strength are called fundamentals.

C is incorrect. The justified P/E being higher than the actual P/E indicates that the stock may be undervalued.

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (a) Contrast the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation and explain economic rationales for each approach.