Perhaps I can share about what I had picked up from one of Damodaran's articles on this topic.
Definition Issues
Most of us are quite familair with terms like P/E ratio etc. However, the P/E ratio could be for different time periods. For example, P/E ratio could be for trailing twleve months (TTM), latest financial year or forward estimates. Moreover, some analysts might have "scrubbed" the financials by removing certain items. Hence, we need to be aware when we compare these ratios between different companies.
Uniformity
You most likely would also want to avoid using multiples that can't be compared across different businesses. For example, if businesses have different fiscal year ends, this means that using the current P/E ratio which compares financial year results would be inaccurate.
Consistency
If you stick to the common multiples touted such as Price/Sales, Price/Earnings and Price/Book ratios, this shouldn't concern you too much. However, the moment you venture in Enterprise Value (EV) multiples, you need to be more careful. For example, you can pair EV / EBITDA, but EV / Net Profit might not be feasible since EV is capital structure neutral. This just means that the proportion of debt and equity does not affect the value of EV.
Sector Over-valuation
One of the implicit assumptions about using such multiples to compare with each other means that the market is valuing these products in a fair range. However, during periods of exuberance or pessimism, the stock you are valuing may be affected by such sentiments.
A good example would have been the DotCom bubble hype, where the whole industry had been overvalued, so even if you had dilligently done your analysis through multiples like P/E ratio, you would have made a huge loss eventually.
One way to mitigate against this is to do a comparison between multiples of certain indexes, and trace it across different periods. However, this is not foolproof also.
Perhaps I can share about what I had picked up from one of Damodaran's articles on this topic.
Definition Issues
Most of us are quite familair with terms like P/E ratio etc. However, the P/E ratio could be for different time periods. For example, P/E ratio could be for trailing twleve months (TTM), latest financial year or forward estimates. Moreover, some analysts might have "scrubbed" the financials by removing certain items. Hence, we need to be aware when we compare these ratios between different companies.
Uniformity
You most likely would also want to avoid using multiples that can't be compared across different businesses. For example, if businesses have different fiscal year ends, this means that using the current P/E ratio which compares financial year results would be inaccurate.
Consistency
If you stick to the common multiples touted such as Price/Sales, Price/Earnings and Price/Book ratios, this shouldn't concern you too much. However, the moment you venture in Enterprise Value (EV) multiples, you need to be more careful. For example, you can pair EV / EBITDA, but EV / Net Profit might not be feasible since EV is capital structure neutral. This just means that the proportion of debt and equity does not affect the value of EV.
Sector Over-valuation
One of the implicit assumptions about using such multiples to compare with each other means that the market is valuing these products in a fair range. However, during periods of exuberance or pessimism, the stock you are valuing may be affected by such sentiments.
A good example would have been the DotCom bubble hype, where the whole industry had been overvalued, so even if you had dilligently done your analysis through multiples like P/E ratio, you would have made a huge loss eventually.
One way to mitigate against this is to do a comparison between multiples of certain indexes, and trace it across different periods. However, this is not foolproof also.