7.6 Multiples, Private Company Valuation, and Equity Case Lab

Why multiples are popular

Relative valuation compares a company with peers, transactions, or its own history. Multiples are popular because they are simple, market-based, and easy to communicate — and dangerous when used mechanically. A low multiple can mean undervaluation, weak growth, poor quality, high risk, or distorted accounting. Common price multiples include price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), and price-to-cash-flow (P/CF). Common enterprise value (EV) multiples include EV/EBITDA, EV/EBIT, and EV/sales.

EV equals market value of equity plus debt minus cash, capturing the value of operating assets available to all capital providers.

Matching numerator and denominator

Price belongs with equity-level denominators — earnings per share, book value per share, sales per share, cash flow per share. EV belongs with firm-level, pre-interest measures such as EBITDA or EBIT. Pairing price with EBITDA, or EV with net income, is a mismatch the exam loves to test, because net income is after interest and belongs only to equity holders. Trailing multiples use reported results; forward (leading) multiples use forecasts and are more relevant when earnings are changing fast but depend on forecast quality. Normalized multiples strip out cyclical extremes, one-time charges, and nonrecurring gains.

Interpreting common multiples

A high P/E can reflect strong expected growth, low risk, or overvaluation; a low P/E can reflect undervaluation, weak growth, poor earnings quality, high leverage, or cyclically peaked earnings. P/B suits banks, insurers, and asset-heavy firms where book value is meaningful, but it understates value when worth comes from internally generated intangibles (brands, software, data). P/S is hard to manipulate and works when earnings are temporarily negative, yet it ignores margins and leverage.

EV/EBITDA compares firms with different capital structures because EBITDA precedes interest, but it ignores capital intensity, taxes, and working capital — a capital-light software firm and a capital-heavy telecom can share an EV/EBITDA while having very different free-cash-flow quality.

Justified multiples

A justified multiple is derived from fundamentals. From the Gordon growth model, the justified leading P/E equals payout ratio / (r − g): higher growth and payout raise it, a higher required return lowers it. The justified trailing P/E equals payout × (1 + g) / (r − g). The justified P/B rises when ROE exceeds the required return; when ROE equals the required return, P/B tends toward one, and when ROE is below it, a premium to book is hard to justify. These links let candidates judge whether an observed multiple is reasonable.

Private company valuation

Private firms use three approaches: the income approach discounts expected cash flows; the market approach applies public-company or transaction multiples; the asset-based approach values assets minus liabilities and suits asset-heavy or liquidation cases. Analysis usually requires normalization — adjusting for above- or below-market owner compensation, related-party rent, nonrecurring items, and tax choices.

Two adjustments are central: a control premium when the buyer gains decision power (a controlling stake is worth more per share than a minority stake), and a discount for lack of marketability (DLOM) because private shares cannot be sold quickly at a fair price. A minority interest in a private firm may warrant both a minority discount and a DLOM. Added risks — customer concentration, key-person dependence, thin disclosure, weaker controls, financing constraints — flow into cash-flow forecasts, the required return, or the selected multiple.

Multiple-comparison pitfalls and the PEG ratio

Mechanical peer comparison fails when accounting and structure differ. Two firms can show different P/E ratios purely because one uses accelerated depreciation, capitalizes versus expenses development costs, or carries more leverage (financial leverage raises both expected return on equity and the riskiness of earnings, complicating P/E comparison). The PEG ratio (P/E divided by expected earnings growth) tries to normalize P/E for growth — a lower PEG suggests a cheaper price per unit of growth — but it ignores risk and assumes a linear relation between P/E and growth, so it is a screen, not a verdict.

Trailing P/E can be distorted by one-time items, which is why analysts use normalized or forward earnings; EV/EBITDA can flatter a capital-heavy firm whose depreciation reflects real, recurring reinvestment that EBITDA ignores.

Reconciling methods into a conclusion

The capstone skill is triangulation. A robust equity conclusion does not rely on one DDM output or one multiple; it asks whether a DCF estimate, a justified multiple, and observed peer multiples point in the same direction, and it investigates the gap when they disagree. If the DDM says a stock is cheap but its EV/EBITDA sits far above peers with similar growth and returns, the analyst questions the DDM's growth and discount assumptions before concluding.

For a private target, the analyst starts from a comparable public multiple, normalizes earnings, then layers a control premium (if a majority stake) and a marketability discount, taking care not to double-count — for example, applying a control premium derived from acquisition data and then also a minority discount would be inconsistent for a controlling-interest valuation.

Integrated equity case workflow

Exam focus

First test whether numerator and denominator belong to the same capital providers: price with EPS is consistent; EV with EBITDA is consistent; EV with net income is not. For private companies, identify the ownership premise — a controlling interest supports a control premium relative to a minority public price, and an illiquid private interest supports a marketability discount.

For integrated cases, move in order: market structure shows how the stock trades, index and efficiency frame benchmarking, security features define the claim, industry and company analysis drive forecasts, DDM and multiples translate forecasts into value, and private-company adjustments refine the conclusion when public liquidity and disclosure are absent.