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J. LIU, D. NISSIM, AND J. THOMAS
multiples.1 We seek to investigate the performance of a comprehensive
list of multiples, and also examine a variety of related issues, such as the
variation in performance across industries and over time and the perfor-
mance improvement obtained by using alternative approaches to compute
multiples.
Although the actual valuation process used by market participants is un-
observable, we assume that stock prices can be replicated by comprehensive
valuations that convert all available information into detailed projections
of future flows. Given this efficient markets framework for traded stocks,
what role do multiples play? Even in situations where market valuations are
absent, either because the equity is privately-held or because the proposed
publicly traded entity has not yet been created (e.g., mergers and spinoffs),
is there a role for multiples vis-a`-vis comprehensive valuations? While the
multiple approach bypasses explicit projections and present value calcula-
tions, it relies on the same principles underlying the more comprehensive
approach: value is an increasing function of future payoffs and a decreasing
function of risk. Therefore, multiples are used often as a substitute for com-
prehensive valuations, because they communicate efficiently the essence of
those valuations. Multiples are also used to complement comprehensive val-
uations, typically to calibrate those valuations and to obtain terminal values.2
In effect, our study documents the extent to which different value drivers
serve as a summary statistic for the stream of expected payoffs, and compa-
rable firms resemble the target firm along important value attributes, such
as growth and risk. We first evaluate value drivers using the conventional
ratio representation (i.e., price doubles when the value driver doubles). To
identify the importance of incorporating the average effect of omitted vari-
ables, we extend the ratio representation to allow for an intercept in the
price/value driver relation. To study the impact of selecting comparable
firms from the same industry, we contrast our results obtained by using in-
dustry comparables (the middle category from the Sector/Industry/Group
classification provided by IBES) with results obtained when all firms avail-
able each year are used as comparables. As in prior research, we evaluate
performance by examining the distribution of pricing errors (actual price
less predicted price, scaled by actual price).
The value drivers we consider include measures of historical cash flow,
such as cash flow from operations and EBITDA (earnings before interest,
1 Studies offeringdescriptiveevidence include Boatsmanand Baskin [1981], LeClair [1990],
and Alford [1992]. Recently, a number of studies have examined the role of multiples for
firm valuation in specific contexts, such as tax and bankruptcy court cases and initial public
offerings (e.g., Beatty, Riffe, and Thompson [1999], Gilson, Hutchkiss, and Ruback [2000],
Kim and Ritter [1999], and Tasker [1998]).
2 Another very different role for multiples that has been examined in the literature is the
identification of mispriced stocks. We do not investigate that role because we assume market
efficiency. Two such market inefficiency studies are Basu [1977] and Stattman [1980], where
portfolios derived from earnings and book value multiples are shown to earn abnormal returns.