Most common errors in valuation by multiples

Learn with our financial academy HowTo the most common errors that occur in the method of valuation by multiples.

Company valuation is the key step in a business valuation process. buyof sale or seeking for search for investors for a company. Through this process it is possible to obtain the company's objective value, a basic instrument for any type of corporate negotiation and fundamental for decision making.

There are several business valuation methods that can be classified into six different groups:

In spite of the multiple options that exist, valuation by multiples is one of the most widely used because it is simple, fast, easy to understand and useful, although it is not the only method, but rather a support or contrast to the discounted cash flow method.

Although it may be a simple method to use, there are numerous errors that can affect the valuation by multiples, and this very important activity of corporate finance yields an incorrect value for the company in question.

USE THE AVERAGE OF MULTIPLES FROM TRANSACTIONS OVER A LONG PERIOD OF TIME

Corporate finance is no stranger to the changes taking place in our society. Thus, the terms, prices and operations closed in the past have little to do with those taking place today.

For this reason, when selecting multiples it is necessary to take into account their context and date, otherwise we may run the risk of using multiples that do not reflect the situation we want to value, i.e. that are not representative of the current operation.

USING THE AVERAGE OF MULTIPLES THAT HAVE A LARGE DISPERSION

When selecting multiples, it is important to take into account their values. It is common that after a selection of comparable companies or transactions, some figures appear far away from others.

At this point, selecting the median to obtain the desired multiple may result in a value that is not very characteristic. Therefore, it is advisable to exclude both the upper and lower values to obtain a more representative sample with less dispersion.

USE MULTIPLES DIFFERENTLY FROM THEIR DEFINITION

Sometimes certain multiples are used while forgetting the existing concept that supports them. For example, a common mistake can be to subtract the financial debt when calculating the price-earnings ratio, which goes against the idea behind this multiple.

Therefore, it is essential to know and understand correctly the theory behind each of them in order to avoid unnecessary operations that may distort their usefulness.

USE THE MULTIPLE OF AN ATYPICAL OPERATION

Along the same lines as described above, there is a risk of selecting operations that do not really represent the situation of the sector, since these operations were carried out under special circumstances and therefore distort the values.

Thus, knowing the operations and companies selected as comparable and the particularities of each one of them as far as possible, thus avoiding deviations that alter our calculation, can be of great help.

USING MULTIPLES THAT GO AGAINST COMMON SENSE

Company valuation is nothing more than an exercise in common sense, combined with a little technical knowledge. In this case, the mistake comes from using multiples that do not make sense.

In this way it is important to understand the values that are chosen and try to understand how the figure that is presented has been arrived at and whether this number is reasonable, adequate to common sense.

USING MULTIPLES WITHOUT USING COMMON SENSE

In this case, the reference is to avoid using multiples automatically and as if it were an automated process. It is not reasonable to use the same multiples for different companies that may present very different realities and data.

Applying the same ratios indiscriminately to all of them without stopping to think about which is the most appropriate for each case can lead to valuation errors that can be avoided if common sense is used when applying them.

SourceCompany valuation, how to measure and manage value creation. Pablo Fernández. 2007.