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Accounting-based market multiples are the most common technique in equity valuation. These multiples are present in analysts' reports and investment bankers' fairness opinions. They also appear in valuations associated with corporate transactions. However, it is difficult to know which multiple to apply to the subject company and most multiples used for valuation are trailing multiples, which are based on historical data. If the value driver of a multiple refers to a forecast instead of a historical number, it is termed "forward-looking". Valuation theory tells us that the value of a firm equals its discounted stream of expected future payoffs. Following this principle, forward-looking multiples are more appropriate for valuation purposes.

Empirical research for the U.S. implies that forward-looking multiples are in fact more accurate predictors of value than trailing multiples. In a sample of 142 U.S. IPOs, Kim & Ritter (1999) find that P/E multiples based on earnings forecasts for the subsequent two years outperform those based on historical earnings. As the analysis moves from trailing to one-year and to two-year ahead forward-looking multiples, the percentage of firms valued within 15.0 percent of their actual stock price increases from 15.0 percent to 19.0 and 36.0 percent, respectively. Liu, Nissim & Thomas (2002), in their broad investigation of U.S. equity markets, show a similar pattern. The median valuation error equals 23.0 percent for inverse P/E multiples based on historical earnings and falls to 18.0 percent and 16.0 percent when moving to one-year and two-year forward-looking multiples. The results of the two studies are intuitively appealing, because earnings forecasts should reflect future profitability and growth better than historical measures. Consistent with this reasoning, the performance increases by lengthening the forecast horizon from one year to two years.

Based on the principles of valuation and empirical evidence, forward-looking multiples are a valuable valuation tool whenever the forecast data for the multiples applied is available for the entire peer group. Forecasts on a broad basis are typically available for EBIT, EBITDA, pre-tax income, and net income.

Category(s): Valuation Thoughts
Posted by Jon Grupp at 08:41 PM | Permalink | Comments (1) | TrackBacks (0)