[ Intro Music ] >> So in this video let's discuss the market multiple's approach to valuation, also known as comparable analysis. So the basic idea behind market multiples is to find a comparable company that should be valued similarly to your firm along various financial metrics. You know, such financial metrics include both market value data and financial accounting data such as, you know, a price-to-earnings ratio. A market-to-book ratio. So the key idea is, find a firm that is comparable to you. Should be valued in the same way that your firm is valued. See how that firm is valued. Apply that market-to-book, or price-to-sales or price-to-earnings ratio of your competitor. Multiply by it your book value or your earnings or your sales, to get an estimate of what your market value would be if you were valued the same way by the market as your comparable firm. That's market multiple analysis in a nutshell. Key assumption. These comparable companies have future cash flow expectations and risk. They're similar to the firm being valued. So this sounds easy in theory, but it's more difficult to, you know, kind of do in practice. So for example, using General Motors is a comparable firm for Tesla, probably doesn't make as much sense as using General Motors as a comparable firm for Ford. Okay? So easy in theory; difficult in practice. How do we compute these comparables? How do we do this comparable analysis? So first, let's start with a sample of firms whose business and financial characteristics are similar to the company being valued. Let's assume that that company has similar financial ratios to the comparable firms. So, for example this could be price-to-earnings. Market-to-book. Total firm market value over sales. You know, total firm market value over earnings before interest and taxes. You kind of get the drill. We just have some financial ratio where it's a market value divided by some accounting number. That's a, you know, the kind of market multiple we'll use. And we'll take that market multiple from the comparable company, apply that to our accounting data to get an estimate of our market value. And when we do this, we need to remember, are we interested in getting total firm value? Are we interested in just getting the part of firm value that will go to equity holders? So if we come up with an estimate of total firm value, if we care about the amount that's going to the stockholders, we'll need to, you know, kind of subtract out the amount that goes to the debt holders to get to the stockholders. So just remember, total firm market value equals the claims of the bondholders, and the claims of the stockholders. Okay. When is a natural time to use this market multiple approach. Okay? A natural application for market multiples is a valuation of a company right before it's having an initial public offering. You can obviously do discounted cash flow analysis at any time, whether the firm is public or private. But if it's private firm, there is no -- by definition there is no publically traded market price. So maybe a way to get a sense of market conditions; market sentiment is find a comparable firm that's already publically traded. Is already on the New York Stock Exchange or NASDAQ or London Stock Exchange. See how the market values that firm. Apply that valuation ratio to your own accounting data to get a sense of how the market would value you, okay? So this is a way to kind of gain insight about market sentiment for a firm that's not yet publically traded. You can also use a market multiples approach for publically traded firms. Firms that already have a stock price. You may think, hey, the market is under-valuing my firm and the cash flow it generates. It can kind of give a sense when you're doing a market multiple analysis, is your, you know, kind of market value kind of correct? Is your, you know, kind of current market value too high or too low? If you think there's other firms that should be valued the same way you are, you do a market multiple analysis. And those firms imply that your stock should be at a higher level, maybe that's a suggestion that you're under valued. Maybe you should consider, you know, a leverage buyout or maybe less dramatic, repurchase some of your stock if you think you're undervalued by the market, for example. You may think about doing this market multiple analysis if you're subject to a takeover bid to get a sense of like, hey, what's a fair, you know, kind of a price to demand from the firm that's seeking to acquire you, for example. So market multiple, useful for both private firms as well as publically traded firms to get a sense of market sentiment, okay? So once we get this estimate from the, you know, kind of market multiples technique, we need to -- we can think about comparing that to the answer from discounted cash flows. So we can look at the valuation from market multiples. We can compare that to the valuation we get from simply doing a discounted cash flow analysis. So natural question is, what if the two approaches differ? You know, market values, are they stirring from fundamentals? If you get, kind of the market multiple answer that is higher than your discounted cash flow, is that kind of a suggestion that like, hey, you know, kind of the market value of your company is higher, that could be justified by the discounted cash flows. Maybe it's a good time to sell stock. Good time to have an IPO. If the reverse is true that the market value implied by the market multiple technique is lower than their discounted cash flow analysis, maybe that's a good time you're under-valued. To repurchase stock; do a leverage bye-out. So maybe you're picking up some clues about market sentiment, okay? Market value straying away from the fundamental cash flow value of the company. On the other hand, it could just simply mean that you screwed up [laughter]. That your market-multiple, comparable company wasn't really comparable. Or that, you know, your cash flow assumptions were wrong. So if the market multiple and the discounted cash flow technique differ, could represent, hey, some market forces. You know, market prices stirring from fundamentals. Or it could just simply reflect that you've kind of screwed up. Made bad assumptions in one or both valuation techniques. And that's why the answers aren't comparable. So that's where the being, you know, kind of approximately right, versus precisely wrong comes in. Problems or limitations, I should say, with you know, kind of the market multiple's approach. We've kind of talked about this. You know, it's easy to do in theory, but in practice can you really find that truly comparable company to do the comparison with? Which ratio should you use? Okay? No one, right answer. You know, should you use price-to-earnings? Price-to-sale? Market-to-book? You know, which one should you pick? No reason you have to limit yourself to, you know, just kind of one. Sensitivity analysis is important here to see what values are implied by multiple -- market multiples, to kind of get some sense. You don't want to just kind of rely on one. You want to get some sense of the distribution of, you know, kind of estimates you get across a lot of different reasonable market multiple valuations. Okay? Another thing to consider with the comparable's approach is does a comparable company have a different capital structure than you do? Leverage. Having more debt leads to more interest payments, okay? Leverage can mechanically affect some financial ratios such as a price-to-earnings, where earnings is net income. Because interest is deductible from net income. So, you know, generally a good idea is to use market ratios that are not affected by leverage. So you don't have simple differences in leverage. Financial structure of the company, affecting the market multiples. Other things you need to, you know, kind of be thinking about. What kind of investments does the firm do? A firm that does research and development may have different patterns in reported earnings than a firm that does capital expenditure, due to the different rules for expensing of those different types of investments.