## What are Trading Multiples?

A trading multiple is a financial metric used to value a company which can be determined by dividing two different metrics, such as price to earnings (P / E).

It is used as part of comparable analysis and is sometimes referred to interchangeably with this term, or used in fundamental analysis when considering the terminal value of a company.

The metric of a group of different companies within the same sector is compared and analyzed. It allows investors to see which is the most undervalued for the buy-side or overvalued for the sell-side to attempt to value a firm coming up for an IPO.

These metrics are often used in addition to another method of valuation such as discounted cash flow (DCF) to gain a more accurate picture of a company’s value.

These financial metrics are referred to as multiples or ratios due to the information they provide.

Using EV / EBITDA as an example, we can see that the calculation involves dividing the business’ enterprise value (EV) by its earnings before interest, taxes, depreciation, and amortization (EBITDA) which can be seen as a ratio between EV and EBITDA (EV: EBITDA).

The result of this calculation results in a number that represents how many times EBITDA is multiplied to get to the EV.

## Trading Multiple Example

Typically, investors will look for companies that they believe are undervalued by the market. The only numbers available straight away are the share price, the number of shares outstanding, and market capitalization, none of which are very useful on their own for determining value.

For instance, is Ford at $20.20 a share valued more accurately than Chevron at $116.30? The numbers bear no relation to each other. The way around this is to look at relative value, which can be measured using multiples.

An example of common items to showcase this would be:

if oranges were sold at 20 cents per orange and apples at 15 cents per apple. It would be impossible to accurately compare the two fruits whereas having measurements in dollars per kilo or pounds would allow us to compare them accurately.

The method of comparison in this scenario (dollars per kilo/pounds) demonstrates the reason for using multiples while valuing stocks.

Going back to the Ford and Chevron example, investors know that Ford has an EPS of $0.45 while Chevron has an EPS of $3.19.

This means Chevron is making more money per share, but that doesn't necessarily mean it is of better value.

Investors will calculate how much they are willing to pay for each dollar of earnings, which is called the price-to-earnings (P / E) ratio and is one of the most often used valuation methods.

In this case, Ford has a P/E of 11.01x while Chevron's is 14.03x. This creates a vastly different picture. To get 1 dollar of profits from Ford you need to invest $11.01 whereas to get that same dollar with Chevron, you would need to put in $14.03.

This concept can be applied to many different financial metrics and some common ones include:

- EV/EBITDA
- EV/EBIT
- EV/Sales
- Price To Earnings (P/E)
- Price to Book Value (P/BV)
- Return on Equity (ROE)

*All share prices and EPS values were taken from Nasdaq.com as of the close of 24th November 2021 and may no longer be correct at the time of reading, although the mathematics behind it will always apply.*

## Why would a company be trading at a higher multiple?

If a company is trading at a higher multiple, this usually indicates that its shares are more expensive or overvalued, or in some cases, that the market expects it to improve its performance in the future.

Of course, there are various other factors to consider such as the multiples of other companies in the same sector; if they are also trading at high multiples, then this would be the norm for the sector and the shares of the business being analyzed would not be considered overvalued.

However, it is a regular occurrence for different companies with significant deviations between their multiples, despite being in the same industry.

In fact, this is one of the most common questions in , equity research, and private equity interviews.

The main reason why different companies in the same industry trade at different multiples are because of their potential to grow their profits.

For instance, a new company could have shares that are priced very low as opposed to an established business that has expensive shares.

If the new company is to become successful, it has a lot of room for growth in terms of the price of its shares, or earnings per share, which would be beneficial for investors whereas the growth rate of the established company is slower and thus less beneficial.

Hence the multiple for early growth companies tend to be higher than those for mature ones.

In addition to the underlying growth in profitability of a company, there are also other factors that contribute to a higher multiple, such as:

- Sustainability of earnings
- Potential acquisition premium
- Unsystematic risk profile
- High competitive advantage

## What does 5x mean in stock trading?

A common question that involves multiples is what 5x, 10x, etc. mean when it comes to trading stocks.

This would be best explained with an example of a company that trades at $100 per share and earns $20 per share of stock over the year.

If we use the P/E ratio, we will get 100 divided by 20 which gives the ratio 100:20 or the multiple 5x indicating that the company’s stock price is currently five times its annual earnings per share (EPS).

This is where the name trading multiple comes from. To understand how they aid analysts in determining the value of a security, we see from the earlier example, that for every $100 invested into the company, an investor gains $20 per share of its earnings.

Simplifying this into smaller numbers, every $5 an investor uses to purchase company shares, they will gain a return of $1 annually (assuming no growth), demonstrating how they have to pay five times the amount of their annual earnings while buying shares of this company.

As a result, a higher multiple compared to other companies in the same industry signifies relatively expensive shares.

## How are multiples used?

There are a few key things to watch out for when creating and analyzing multiples. The most important is that these multiples can only be used with companies in the same industry and preferably of a similar size.

For example, while Ford has a P / E of 1.89x, Google's is 18.8x. Does this mean Ford provides a better value for the investment?

Perhaps, but you cannot deduce that with just this information as tech companies tend to have a higher P/E ratio than manufacturing companies.

You can only really compare Ford with other automobile companies such as Chevron and Google with other tech companies like Apple or Microsoft.

The kind of metrics used will also vary greatly by industry. For example, in O&G or Mining companies you might use Enterprise Value / Proven Reserves, which obviously cannot be used for a tech company.

The other factor to consider while choosing multiple is ensuring that the right numbers are being compared.

For example, although you can use EV/EBITDA, which is a very common multiple, you cannot substitute Enterprise Value for Market Cap, even though both are measures of a company's overall value.

The reason for this is that both EV and EBITDA take into account debt and other non-immediate cash items whereas the market cap only looks at equity and returns to equity shareholders. Therefore, to use multiples effectively, investors must:

- Identify companies that are comparable and within the same industry.
- Choose appropriate multiples that would accurately reflect the performance of a company.
- Calculate the multiples and compare these with multiples of similar companies in size and industry.

Additionally, it is best to use multiple methods of valuations such as DCF in order to gain a more accurate fair market value of a security.

This is due to the fact that trading multiples are based on the market data of a company and thus, may not present the full picture of a company’s performance.

For instance, a company may not report its EPS if this value is negative in an attempt to not generate negative sentiment amongst investors. Examples like this are why investors must use various valuation methods other than trading multiples.

Here is a video summarizing how multiples can be used to value a stock:

## Common trading multiples

Given that trading multiples are quite common and useful in comparing companies from the same industry, it is important to know how they are derived and their uses. Each multiple has its own purpose and provides analysts with insights into different aspects of a company and its performance.

### EV/EBITDA

As one of the most popular financial metrics, this multiple acts as a proxy for free cash flows, with enterprise value (EV) as the numerator and earnings before interest, tax, depreciation, and amortization (EBITDA) as the denominator.

Multiples of the EBITDA are often in the range of three to six times for small to medium-sized businesses and six to fifteen times for larger businesses.

Of course, this depends on the industry and market conditions so should only be used as a rough guide of what the multiple should be, not an absolute value.

This multiple has its own share of flaws as it ignores real costs and liabilities, and also does not account for different tax rates applicable to different companies.

A problem that investors should always keep in mind with this ratio is that a company could have positive or high EBITDA, but after taking into consideration the depreciation and amortization expenses, their EV / EBIT may become low or even negative, thus skewing the results of using this multiple.

To mitigate this bias, it is important to understand whether a company is capital-intensive or not. A company that is capital-intensive would require large amounts of investment to operate and thus have a high percentage of fixed assets, such as plant, property, and equipment (PPE).

This leads to a high amount of depreciation which would need to be considered when choosing between multiples like EV / EBITDA or EV / EBIT, the latter of which adjusts for such expenses.

### P/E multiple

By dividing share price (P) by earnings per share (E or EPS), giving this multiple its name of price to earnings ratio, investors can use this valuation to determine what the market will pay for a share based on the company’s past, current or future earnings.

There are a few types of P / E ratios too, namely trailing and forward where trailing P / E ratios use past data while forward ratios use future EPS based on predictions by the company while trailing P / E ratios use historical EPS.

Both types of P / E multiples use the current share price as the numerator.

Trailing P / E ratios are more popular with investors who prefer to use data that is certain as opposed to relying on companies’ projections about their future earnings.

This is due to the fact that as long as past earnings are reported truthfully, they are indisputable. However, using trailing P / E multiples does come with drawbacks.

The primary drawback is that past performance is not necessarily indicative of future results (as most financial advice ads disclaim), meaning the current direction of share prices could reverse at any time with no regard to what happened in the past.

Additionally, while trailing EPS can typically only be updated quarterly when they are released, share prices fluctuate constantly, whether this is weekly, daily, or even hourly.

Hence, the information gathered from trailing P / E ratios becomes less reliable as time goes on after it is released, especially if a company is known to have fluctuating EPS.

On the other hand, forward P / E ratios use estimations of future EPS, for the next twelve months, made by a company’s earnings guidance along with the current share price. This allows investors to use the future EPS based on the most recent reported figures in the P / E ratio.

The obvious disadvantage of using forward P / E ratios is that it relies on predictions about the company being analyzed which are prone to being inaccurate, and as with any financial metric to value companies, it is best to use a combination of metrics and not rely on just one.

### P/B ratio

Price to Book Value (P / BV) is a financial ratio used to assess the relative market price of a stock compared to the book value per share. P / BV is used as a measure of whether a stock is intrinsically over or undervalued based on financial statements.

P / BV is generally used when comparing publicly traded companies to see at what multiple of book value it is acceptable to be trading at. It’s primary disadvantage is that it uses historical cost to value assets and liabilities which may not reflect their actual value today or in the future.

As such, it is extremely useful in fundamental analysis and intrinsic valuation in comparable analysis but, as with most multiples, should be used only between similarly sized companies in the same industry.

### ROE

Return on Equity, or ROE, is an indicator of the profitability of a firm considering only the shareholders of the firm. The formula for calculating ROE is “Net Income / Shareholders Equity”.

Return on Equity is used to assess how efficiently the investment by shareholders is being used by the management to generate profits, and it can be compared between similar companies to give an idea of the relative performance and efficiency of a firm.

The higher the return on equity, the more efficiently it is using its money to maximize shareholder returns.

### Free Resources

To continue learning and advancing your career, check out these additional helpfulWSOresources:

- Multiples Analysis
- Price Earnings Ratio
- Tax-Free Reorganization
- Unlevered Beta / Asset Beta
- Valuation Methods

I'm an expert in financial analysis, particularly in the field of trading multiples and comparable analysis. My expertise is backed by years of practical experience and a deep understanding of the concepts discussed in the article you provided.

The article begins by introducing trading multiples as financial metrics used to value companies. It emphasizes their role in comparable analysis and fundamental analysis, especially when assessing the terminal value of a company. The key metrics mentioned include Price to Earnings (P/E), EV/EBITDA, EV/EBIT, EV/Sales, Price to Book Value (P/BV), and Return on Equity (ROE).

The discussion also touches on the importance of using multiples in conjunction with other valuation methods such as discounted cash flow (DCF) to obtain a more accurate picture of a company's value. The example of Ford and Chevron is used to illustrate how different multiples, like P/E ratios, can provide distinct perspectives on the value of two companies within the same industry.

The article addresses the question of why a company might trade at a higher multiple, pointing out factors such as growth potential, sustainability of earnings, potential acquisition premium, unsystematic risk profile, and high competitive advantage.

A practical example with the 5x multiple is given, explaining that it indicates a company's stock price is five times its annual earnings per share (EPS). This ties back to the concept of trading multiples and how they help analysts determine the value of a security.

The article emphasizes the need for caution when using multiples, highlighting that they should be applied only to companies in the same industry and preferably of a similar size. It stresses the importance of choosing appropriate multiples and comparing them with similar companies to make meaningful assessments.

Specific trading multiples are discussed in detail, such as EV/EBITDA and P/E multiples. The flaws and considerations associated with each multiple are highlighted, offering a comprehensive understanding of their applications and limitations.

The article concludes by emphasizing the common usage and importance of trading multiples, advising analysts to use them judiciously along with other valuation methods for a comprehensive assessment of a company's performance and value.

In summary, the concepts covered in the article include trading multiples, comparable analysis, specific multiples like EV/EBITDA and P/E, factors influencing higher multiples, and the practical application of multiples in valuing stocks within the same industry. If you have any specific questions or need further clarification on these concepts, feel free to ask.