Applicability of multiples and limitations

The allure of multiples is that they are simple and easy to relate to. They can be used to obtain estimates of value quickly for firms and assets, and are particularly useful when there are a large number of comparable firms being traded on financial markets, and the market is, on average, pricing these firms correctly. In fact, relative valuation is tailor made for analysts and portfolio managers who not only have to find under valued equities in any market, no matter how overvalued, but also get judged on a relative basis. An analyst who picks stocks based upon their PE ratios, relative to the sectors they  operate in, will always find under valued stocks in any market; if entire sectors are over valued and his stocks decline, he will still look good on a relative basis since his stocks will decline less than comparable stocks(assuming the relative valuation is right). By the same token, they are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly similar in terms of risk and growth, the definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a group of comparable firms to confirm his or her biases about a firm's value. While this potential for bias exists with discounted cash flow valuation as well, the analyst in DCF valuation is forced to be much more explicit about the assumptions which determine the final value. With multiples, these assumptions are often left unstated. The other problem with using multiples based upon comparable firms is that it builds in errors (over valuation or under valuation) that the market might be making in valuing these firms. If, for instance, we find a company to be under valued because it trades at 15 times earnings and comparable companies trade at 25 times earnings, we may still lose on the investment if the entire sector is over valued. In relative valuation, all that we can claim isthat a stock looks cheap or expensive relative to the group we compared it to, rather than make an absolute judgement about value. Ultimately, relative valuation judgements depend upon how well we have picked the comparable companies and how how good a job the market has done in pricing them.