Discounting cash flows (DCF) is the preferred way to valuating a firm’s worth but is a lengthy process which requires skill and expertise. Using multiples for valuations is convenient and straightforward but it can also be very misleading. And that is an understatement.
In DCF a firm’s future cash flows are used to determine its current value by adjusting for risk and time. Multiples such as profit, capital, assets and sales are used to determine values of companies by comparing similar companies to one another and by direct multiplying. Multiples are also used to compare various companies in terms of profitability, effectiveness and more. The most common use of profit multiples, for example, is in comparing valuations of similar companies in the same industry.
For a better understanding of valuation techniques and the appropriate use them a look into the pros and cons of each valuation technique is required. Obviously the shortfalls of one technique are the other’s advantages. Here are the main points of reference between the two techniques:
1. Simplicity Using multiples is simple. Extrapolating data is easy and multiplying is very basic math. DCF requires skill and expertise and is much more complicated technically.
2. Informative – Using multiples often yield significant data in a very short time. DCF is also very informative but requires time to be invested. Using multiples also help in quickly comparing two companies and might yield more relevant information.
3. Forecasting – Unlike DCF multiples use existing date which is, of course, their Achilles heel. Using DCF requires forecasting future cash flows which are, at times, quite difficult.
4. Sensitivity to various accounting choices and alternatives Using multiples is very sensitive to various accounting choices and alternatives. Different methods of revenue recognition adopted by a company might distort a profit multiplier quite badly. DCF does not suffer this shortfall as a company’s cash flows are not affected by accounting for revenue for the long term.
5. Sensitivity to unique events Using multiples is also sensitive to unique events such as unique revenues or expanses which should be corrected, valuation wise. These one time occurrences will affect multiples and could have very significant implications. In DCF these one time occurrences are cleaned out as only cash flows matter.
6. Unique future circumstances – Multiples rely on past data. A company just might have significant potential or benefiting circumstances which should be taken into account in a valuation. In DCF future circumstances are accounted for through cash flow forecasts. A potential for market expansion would be reflected in future cash flows.
A direr problem with using multiples is that the search for similar companies often leads us to compare different companies entirely. In order to really identify similar companies we need to carefully examine growth, dividend pay-out ratio, discount rate and beta (Theory wise).
To conclude, using multiples is appropriate when “quick and dirty” analysis and benchmarking is required. When a thorough diligent valuation is needed using DCF is the only way to receive more reliable results.