Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies

Authors

  • Robert W. Holthausen,

    1. ROBERT W. HOLTHAUSEN is the Ernst and Young Professor and the Nomura Securities Professor of Accounting and Finance, as well as Chair of the Accounting Department, at the University of Pennsylvania's Wharton School of Business. Bob's research has studied the effects of management compensation and governance structures on firm performance, the effects of information on volume and prices, corporate restructuring and valuation, the effects of large block sales on common stock prices, and numerous other topics.
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  • Mark E. Zmijewski

    1. MARK E. ZMIJEWSKI is the Leon Carroll Marshall Professor of Accounting at The University of Chicago's Booth School of Business. The focus of Mark's extensive academic writings and consulting are issues related to valuation, security analysis, and the effect of financial and other disclosures on capital market participants and security prices.
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  • This article is based on on Chapters 13 and 14 of Corporate Valuation: Theory, Practice and Evidence, by Robert Holthausen and Mark Zmijewski, © 2012, Cambridge Business Publishers.

Abstract

An important part of the market multiple valuation process is selecting companies for comparison that are really comparable to the company being valued. The goal of assessing comparability is to align the relevant value drivers—especially risk and growth—of the comparable companies with those of the company being valued.

In this paper, the authors examine the relevant value drivers for commonly used market multiples such as EBIT and EBITDA. They show that, in addition to risk and growth, analysts doing market multiple valuations need to take account of differences in variables such as cost structure, working capital, and capital expenditure requirements when assessing comparability.

The authors also show that the degree to which different value drivers are important for assessing the comparability of companies differs across commonly used market multiples. In other words, some multiples are more sensitive than others to changes in certain value drivers. For example, when using a multiple like EBITDA in which certain expenditures (such as capital investments, working capital investments, and some expenses) are not deducted in the calculation of the denominator, assessing comparability based on such expenditures is more important than when using a multiple like free cash flow that deducts that expenditure in calculating the denominator. Or to cite another example, since EBIT and EBITDA make no attempt to reflect income taxes, using income tax cost structures to assess comparability is more important for enterprise value multiples based on these measures than for enterprise value multiples based on “after-tax” measures of income such as unlevered earnings or free cash flow.

In addition, not all multiples control for differences in cost structure, such as cost of goods sold or SG&A. If a multiple is affected by differences in those value drivers, the comparable companies must be similar to the company being valued on that dimension. Finally, the authors show that differences in capital expenditure and working capital requirements can also have large effects on certain multiples; and as a result, such value drivers also must be considered when assessing comparability.

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