## **Learning Outcomes**

After reading this article, you will understand the principles of relative valuation techniques used to estimate business and share values. You will be able to explain and apply earnings, sales, and book multiples, identify when they are appropriate, and describe the key advantages and limitations of each approach for ACCA Financial Management (FM) exam scenarios.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand and apply relative valuation techniques. For revision, focus on:

- The use of income- and asset-based valuation techniques
- The calculation and application of price/earnings (P/E), earnings yield, sales, and book value multiples
- When and why relative valuation methods are used versus asset-based or DCF models
- The strengths and limitations of using market-based multiples in valuing businesses
- How to adjust and interpret multiples for different company sizes and risk profiles

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. A comparable listed company has a P/E ratio of 10 and EPS of \$0.80. Estimate its share value using the earnings multiple.
2. Explain the main limitation of using industry-average sales multiples to value a private company.
3. State two reasons why a company’s book value multiple may give a value below its market price.
4. True or false? Using relative valuation requires finding comparable companies with similar risk and growth prospects.

## **Introduction**

Relative valuation is widely used in practice to estimate the value of a business by comparing it to similar firms. Instead of focusing on the company’s individual assets or discounting its future cash flows, relative valuation uses price multiples taken from comparable businesses—such as profits, sales, or book value—to arrive at a current value estimate.

This approach is particularly useful when a full discounted cash flow analysis is not feasible or when market data on similar companies is readily available. For ACCA FM students, the ability to select, calculate, and interpret multiples-based valuations is regularly assessed in both calculation and written questions.

> **Key Term: relative valuation**
> The process of estimating the value of a business or share by applying valuation multiples from similar, comparable businesses, rather than by analyzing assets or discounted future cash flows.

## **WHAT ARE VALUATION MULTIPLES?**

Valuation multiples relate the market value of a company (or its shares) to a selected financial metric. Commonly used multiples include:

- **Earnings multiples** (e.g., price/earnings ratio, P/E)
- **Sales multiples** (e.g., price/sales ratio)
- **Book value multiples** (e.g., price/book value ratio or market-to-book)

Each multiple reflects different aspects of a business and is chosen based on data availability and sector norms.

> **Key Term: earnings multiple**
> A value derived by dividing the market price or value of a business by its earnings (usually using the P/E ratio for shares or company value to net profit for businesses).
>
> **Key Term: sales multiple**
> A value calculated by dividing the market price or business value by sales (revenue). Also known as the price-to-sales ratio.
>
> **Key Term: book multiple**
> The ratio of market price or business value to the book (accounting) value of equity, commonly called the price-to-book ratio.

## **APPLYING RELATIVE VALUATION TECHNIQUES**

### Earnings Multiples

The most widely used earnings multiple is the P/E ratio:

$$
\text{P/E ratio} = \frac{\text{Share Price}}{\text{Earnings per Share (EPS)}}
$$

To value an unlisted or target company, the P/E ratio of a comparable listed firm (or sector average) is multiplied by the target’s earnings:

$$
\text{Value per share} = \text{Earnings per share} \times \text{Comparable P/E}
$$

This approach is common in project appraisal and acquisition contexts.

### Sales Multiples

The price/sales ratio (P/S ratio) is often used for businesses with unstable or negative earnings, such as start-ups or firms in cyclical industries. The calculation is:

$$
\text{P/S ratio} = \frac{\text{Market Value of Equity}}{\text{Annual Sales}}
$$

To estimate value, multiply the target company’s sales by the comparable P/S ratio.

### Book Value Multiples

The price/book value ratio (P/B ratio) is useful for firms where asset values are significant, such as banks or property companies:

$$
\text{P/B ratio} = \frac{\text{Market Value of Equity}}{\text{Book Value of Equity}}
$$

To estimate an unlisted company’s value, apply the P/B ratio from similar listed firms to its own book value.

## **CHOOSING AND ADJUSTING MULTIPLES**

When using multiples, it is critical to ensure that the comparator companies are similar in essentials such as size, growth, risk, and accounting policies. Adjustments should be made if there are major differences.

Multiples for private companies are usually “discounted” compared to listed companies to reflect lower marketability and potentially higher risk.

### **Worked Example 1.1**

_A transport business generated \$800,000 profit after tax last year. Similar listed businesses have an average P/E ratio of 6. If the unlisted company is less liquid, you decide to use a P/E multiple of 5. What is the estimated value?_

> **Answer:**
> Value = \$800,000 × 5 = \$4,000,000.

### **Worked Example 1.2**

_A software start-up has annual revenue of \$2 million but negligible profits. Sector P/S multiples are typically 3 for comparable listed companies. Estimate its value using the sales multiple._

> **Answer:**
> Value = \$2,000,000 × 3 = \$6,000,000.

### **Worked Example 1.3**

_An asset management company has a book value of \$15 million. The average price/book ratio of listed peer firms is 1.8. Estimate its value and explain a key limitation._

> **Answer:**
> Value = \$15 million × 1.8 = \$27 million.  
> Limitation: Book value may not reflect economic reality, especially if intangible assets are understated.

## **STRENGTHS AND LIMITATIONS OF RELATIVE VALUATION**

### Strengths

- Quick to apply; does not require complex forecasts
- Uses up-to-date market data from similar companies
- Commonly accepted in practice, especially for minority interests

### Limitations

- Requires truly comparable companies—differences in risk, growth, or accounting can distort results
- Multiples may be inflated in market bubbles or depressed in downturns
- Does not capture company-specific strengths or weaknesses
- Not reliable for companies with unusual business models or poor-quality accounts

### **Revision Tip**

Focus on which multiple is most appropriate in specific industries. For example, use sales multiples for early-stage tech businesses and book multiples for banks.

### **Exam Warning**

Do not blindly apply a listed company’s multiple to a private company without adjusting for size, risk, and liquidity differences.

## **Summary**

Relative valuation is a practical method relying on applying market-derived multiples to key financial metrics of a business. Commonly used multiples are earnings (P/E), sales (P/S), and book value (P/B). Always check for differences in risk, profitability, and accounting when choosing comparators, and critically assess both the advantages and drawbacks in applying these methods to ACCA FM scenarios.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and explain relative valuation and the purpose of valuation multiples
- Calculate and interpret earnings (P/E), sales, and book value multiples
- Select suitable comparables and adjust multiples for business differences
- Recognize the advantages and limitations of each relative valuation approach
- Apply multiples to estimate values for unlisted companies and interpret results

## **Key Terms and Concepts**

- relative valuation
- earnings multiple
- sales multiple
- book multiple

Relative valuation - Earnings, sales, and book multiples