Advantages and Disadvantages of Multiples

Here are the primary benefits of using multiples:

• Universally Used: Multiples are simple to calculate and are universally used. Due to their broad use, multiples allow you to quickly evaluate and rank potential investments. 
• Simplicity: Multiples are easy to use and are simpler and faster than, for example, calculating the internal rate of return. 
• Facilitates Easy Comparison: Multiples make comparing an investment’s returns to other investments – such as real estate, stocks, bonds, or other businesses – quick and easy. 

There are several primary disadvantages of using multiples. Multiples don’t account for: 

• Time: Multiples don’t account for the impact of time. To do so, use the internal rate of return.
• Leverage: Multiples don’t account for the effect of leverage on cash flows and, therefore, returns. To calculate the impact of leverage, either use “cash-on-cash return” or IRR. As leverage increases, the potential for gains or losses increases, as well as risk. Also, the higher the interest rates, the greater the amount of debt service and the lower the returns. In other words, returns are higher when interest rates are lower if leverage is used, but lower interest rates tend to drive up the price of businesses, thereby offsetting the impact of higher returns. 
• Capital Appreciation: Multiples don’t consider the effect of capital appreciation. In most cases, only the ongoing cash flow, or EBITDA, is considered and not the impact of growth on the value of a business. 
• Potential: Multiples don’t consider the value of potential. If you’re comparing two investments with similar rates of return, but one investment is highly scalable and has higher potential, such as a software business, then, obviously, that investment may be more attractive. So, future earnings, and therefore potential, use discounted cash flow.
• Risk: Multiples don’t consider the impact of risk on potential returns. If you’re comparing two investments – real estate versus a small business, for example – and the returns are similar, but one investment is less risky, such as real estate, the less risky investment will be considered more attractive. 
• Inflation: Multiples must be used carefully when comparing investments in time periods with significantly different inflation rates. To do so, use the real rate of return.

A multiple is a helpful tool, but you should use them with caution. Being aware of their limitations and their intended goals is important when using multiples to compare investments.