The Proper Use of Multiples in Valuation

"Discounted cash flow valuations are the best way to assess the value of projects, but they are only as accurate as the forecasts behind them. A careful review of a company's multiples—and those of its competitors—can help verify those underlying forecasts. However, executives must be critical consumers of published multiples and probe unexpected differences...

A properly executed multiples analysis can make financial forecasts more accurate...Any analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating the key ingredients of corporate value—ingredients such as a company's return on invested capital (ROIC), its growth rate, and its weighted average cost of capital—can lead to mistakes in valuation and, ultimately, to strategic errors...

Four basic principles can help companies apply multiples properly: the use of peers with similar ROIC and growth projections, of forward-looking multiples, and of enterprise-value multiples, as well as the adjustment of enterprise-value multiples for nonoperating items."

Read more in this McKinsey Quarterly article.