2.2.3 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Match a valuation numerator to its earnings denominator.
- Select and question comparable companies.
- Build an enterprise-to-equity range.
2.2 · Valuation
Define the cash flow
Valuation · the work you will do
- 1Define the cash flow
- 2Make assumptions explicit
- 3Estimate a range
- 4Compare with price
Before you begin
One company trades at 5x EBITDA and another at 9x. Is the first automatically cheap?
Write your first response before continuing.
Video coming soon · about 3 minutes
Relative Valuation
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. One company trades at 5x EBITDA and another at 9x. Is the first automatically cheap? Take a first view. You can change it when you have considered the evidence.
P/E compares equity value with earnings attributable to the matching shareholders. EV/EBITDA compares a defined enterprise value with a compatible operating earnings measure. EV/revenue can help when profit is immature, but says little about the margin or reinvestment needed to turn sales into cash. Keep numerator, denominator, currency, period and consolidation scope aligned. A negative or near-zero denominator can make a multiple misleading.
A shared industry label is only a starting point. Compare product mix, geography, size, growth, margins, capital intensity, financing and accounting. Explain inclusion and exclusion before looking at the valuation result. Otherwise a chosen peer set can simply confirm the desired answer. A private transaction comparison may contain control terms and deal-specific effects absent from a public minority-share trading comparison.
Verify historical versus forecast metrics, adjust inconsistencies transparently and use a justified range or central measure. Multiply the selected multiple by the compatible company metric, then bridge enterprise to equity if required. Account for other claims and non-operating assets when relevant. Label every simplification rather than presenting the exercise bridge as universally complete.
A lower multiple might reflect mispricing, but also weaker growth, cyclicality, customer concentration, low cash conversion or higher risk. Peer multiples can all be optimistic together. Cross-check with the company’s economics and a cash-based valuation. A discrepancy between revenue and profit multiples is a prompt to inspect margins and peer quality, not automatically a reliable wide valuation range.
Let's work through Harbour trading comparables · invented teaching inputs. Assume independently selected comparable firms support 4.5–5.5x the same-period EBITDA. Harbour EBITDA is £42m; debt £50m; excess cash £30m; shares 20m. These multiples are hypothetical inputs, not current market benchmarks. Pause here and try the calculation or reasoning before continuing.
Low EV = 4.5 × 42 = £189m; high EV = 5.5 × 42 = £231m. Low equity = 189 − 50 + 30 = £169m; high equity = 231 − 50 + 30 = £211m. Per-share range = 169/20 to 211/20 = £8.45–£10.55. Observed price £8 implies EV 180/EBITDA 42 = 4.29x, approximately.
The gap is a question, not a recommendation. The peer assumptions, financial metric and underlying risk must survive scrutiny.
Now try the choices in this lesson. If your answer changes, identify the reason. Build an enterprise-to-equity range. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
Match claims and metrics
P/E compares equity value with earnings attributable to the matching shareholders. EV/EBITDA compares a defined enterprise value with a compatible operating earnings measure. EV/revenue can help when profit is immature, but says little about the margin or reinvestment needed to turn sales into cash. Keep numerator, denominator, currency, period and consolidation scope aligned. A negative or near-zero denominator can make a multiple misleading.
Choose economic peers
A shared industry label is only a starting point. Compare product mix, geography, size, growth, margins, capital intensity, financing and accounting. Explain inclusion and exclusion before looking at the valuation result. Otherwise a chosen peer set can simply confirm the desired answer. A private transaction comparison may contain control terms and deal-specific effects absent from a public minority-share trading comparison.
Apply the selected range
Verify historical versus forecast metrics, adjust inconsistencies transparently and use a justified range or central measure. Multiply the selected multiple by the compatible company metric, then bridge enterprise to equity if required. Account for other claims and non-operating assets when relevant. Label every simplification rather than presenting the exercise bridge as universally complete.
Investigate the discount
A lower multiple might reflect mispricing, but also weaker growth, cyclicality, customer concentration, low cash conversion or higher risk. Peer multiples can all be optimistic together. Cross-check with the company’s economics and a cash-based valuation. A discrepancy between revenue and profit multiples is a prompt to inspect margins and peer quality, not automatically a reliable wide valuation range.
Harbour trading comparables · invented teaching inputs
Assume independently selected comparable firms support 4.5–5.5x the same-period EBITDA. Harbour EBITDA is £42m; debt £50m; excess cash £30m; shares 20m. These multiples are hypothetical inputs, not current market benchmarks.
- Low EV = 4.5 × 42 = £189m; high EV = 5.5 × 42 = £231m.
- Low equity = 189 − 50 + 30 = £169m; high equity = 231 − 50 + 30 = £211m.
- Per-share range = 169/20 to 211/20 = £8.45–£10.55.
- Observed price £8 implies EV 180/EBITDA 42 = 4.29x, approximately.
The gap is a question, not a recommendation. The peer assumptions, financial metric and underlying risk must survive scrutiny.
Put it into practice
1. Select the peers
For Harbour, a profitable equipment and servicing business, compare a mature machinery firm, a loss-making app and a service contractor. Give inclusion conditions.
Record your response in your workbook before opening feedback.
Compare with a model response
Machinery may fit manufacturing economics; a service contractor may fit recurring service revenue. The app is weak unless a specific shared business characteristic can be justified. Use segment economics rather than logos.
2. Check the numerator
A student multiplies £24m net profit by 10x, calls it EV and subtracts debt. Correct the logic.
Record your response in your workbook before opening feedback.
Compare with a model response
A matching P/E gives equity value of £240m under the simplified assumptions. Subtracting debt again confuses equity and enterprise claims.
3. Defend the range
Give two reasons Harbour could deserve a lower multiple than its peers and one test for each.
Record your response in your workbook before opening feedback.
Compare with a model response
Customer concentration could warrant a discount: inspect contract renewals. Higher maintenance capex could lower cash conversion: reconcile asset age and investment requirements. Evidence is needed, not a label-based discount.
Jargon buster
Trading comparable
A publicly traded business used as a valuation reference.
P/E
Equity price or value divided by compatible earnings.
EV/EBITDA
Enterprise value divided by matching EBITDA.
Forward multiple
A multiple using a stated future-period estimate.
Peer selection
A reasoned choice of economically relevant comparators.
Net debt bridge
The defined adjustment between enterprise and equity value.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138 connections: 3.1.4 financial management, 3.3.3 strategy/investment appraisal, 3.3.4 change and uncertainty; Annex 6 quantitative interpretation; AO2–AO4 application, analysis and evaluation. Enterprise DCF, WACC, trading multiples and SOTP are investing enrichment, not prescribed AQA company-valuation methods.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Match a valuation numerator to its earnings denominator. Select and question comparable companies. Build an enterprise-to-equity range.