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Investors use different tactics to highlight and identify attractive investment opportunities. Many investors employ the use of fundamental analysis to help pinpoint companies that are undervalued - or even overvalued in the case of selling stock in a portfolio to take profit.
One tool that those who use fundamental analysis is that of investment multiples. But what is a multiple? And how can one be used to help identify good buys or sells? Here, in this article, we look to answer those questions so that you can arm yourself with the knowledge that can help you make the best investment decisions for you.
A multiple is simply a measure of a company by comparing two different pieces of financial data from a company. You can make a multiple of pretty much anything - though some are more useful than others to compare. They are designed to help compare different sized companies to each other as well as a simple measure of a company’s performance. Multiples can be used to measure a company’s performance in terms of its growth or productivity.
While it is possible to make a multiple out of any two pieces of financial data from a company, it does not mean that you should or that all will be useful. The following three investment multiples are widely used thanks to their use at highlighting when a company is overvalued or undervalued, as well as how efficient it is.
P/E is the commonly used Price to Earnings ratio. It is a quick and easy multiple to calculate as you simply take the trading price of the stock and divide it by the earnings per share or EPS. In general, a company that has a very high P/E is seen as overvalued. I.e. it does not make much in terms of earnings per every share of it - and vice versa for a company with a low P/E multiple.
EV stands for Enterprise value while EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization. Enterprise value is not simply a company’s market cap however - as seen in stock price tables. Instead, investors will take a market cap and add back in any debt while taking out any cash. The multiple therefore divides the enterprise value with a company’s earnings. In general, the smaller the number, the better.
The EV/Sales ratio is one that uses the Enterprise value again with the sales of a company in any one year. It’s a good measure to use as a company’s sales are a relatively easy figure to ascertain without being too easily manipulated. Enterprise value is a fuller picture than a company’s market cap number, improving the use of the metric further. When using this multiple to identify a good investment opportunity, it can be beneficial to compare your figures with like for like companies.
Investing can be a complicated task. However, the use of multiples can be a tool you use to help take some complications out. That being said, this form of fundamental analysis may add a layer of complexity to some investors, further confusing their investment decisions. Only use multiples as a form of analysis if you know how to use them properly and effectively.
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