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Common Characteristic-Based Ratios or Multiples
The following subsections contain a non-exclusive list of characteristic-based ratios used to value a business. These ratios are derived from a comparable transaction, firm, or industry. Sometimes, multiple ratios are used to derive a single valuation for a target business.
Price/Earnings Ratio (P/E Ratio)
The price/earnings (P/E) ratio is most commonly used with public companies. It represents the ratio of the earnings of company equity to the number of shares of equity outstanding. It generally involves a public company’s stock price divided by the average earning per share during four quarters. As such, the ratio varies based upon the quarters used in the ratio. The trailing P/E ratio is the current stock price divided by the average earnings per share during previous four quarters of earnings. The forward P/E is current stock price divided by a forecast of the next four quarters earnings. The forward P/E ratio is often used when past earnings are negative or are seriously distorted due to extraordinary losses or gains. The straddle P/E ratio is the current stock price divided by the average earnings per share during the past two quarters of earnings plus a forecast of the next two quarters.
Price/Earnings Growth Ratio
A variation of the P/E ratio is the price/earnings to growth (PEG) ratio. This ratio is used to value a company that has (or is assumed to have) a constant growth rate. PEG is calculated by dividing the company’s P/E ratio by the expected annual growth rate in the company’s earnings. This technique provides an efficient method for adjusting the P/E ratio to compare firms with different growth rates.
Price/Cash Flow Ratio
Price to cash flow uses the total value attributable to a company compared to the annual cash flow that the firm generates. The definition of cash flow may vary between companies. A common definition of cash flow includes all earnings plus any non-cash charges by the company. Firms may use the earnings before interest and taxes (EBIT) or interest, taxes, depreciation, or amortization (EBITDA) to represent the company’s cash flow.
The price/sales ratio compares the total price of the company to the total sales. Sales may include all sales with or without regard to bad accounts. In any event, the Price/Sales ratio excludes other forms of revenue not directly related to the company’s primary service(s) or product(s).
In some events, using value characteristics other than accounting variables may provide a more accurate valuation of the target business. Operating characteristics are a common metric for closely-held businesses, cross-border deals, and specialty businesses. For example, a social media firm may be valued based upon the number of users; as apposed to focusing on firm revenue or assets. Cellphone companies may be valued based upon a dollar value for each individual in a population served.
Another method that may provide an accurate depiction of the value of a firm’s equity is the market/book ratio. This method is used to in conjunction with a P/E ratio. The market/book ratio is the total value (market value) of a company’s equity divided by that company’s net worth as recorded on the balance sheet. This method is common specialty industries, such as banks and large retailers.