Senior executives know that not all valuation methods are created equal. In our experience, managers dedicated to maximizing shareholder value gravitate toward discounted-cash-flow (DCF) analyses as the most accurate and flexible method for valuing projects, divisions, and companies. Any analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating the key ingredients of corporate value—ingredients such as a company’s return on invested capital (ROIC), its growth rate, and its weighted average cost of capital—can lead to mistakes in valuation and, ultimately, to strategic errors.

We believe that a careful analysis comparing a company’s multiples with those of other companies can be useful in making such forecasts, and the DCF valuations they inform, more accurate. Properly executed, such an analysis can help a company to stress-test its cash flow forecasts, to understand mismatches between its performance and that of its competitors, and to hold useful discussions about whether it is strategically positioned to create more value than other industry players are. As a company’s executives seek to understand why its multiples are higher or lower than those of the competition, a multiples analysis can also generate insights into the key factors creating value in an industry.

Yet multiples are often misunderstood and, even more often, misapplied. Many financial analysts, for example, calculate an industry-average price-to-earnings ratio and multiply it by a company’s earnings to establish a “fair” valuation. The use of the industry average, however, overlooks the fact that companies, even in the same industry, can have drastically different expected growth rates, returns on invested capital, and capital structures. Even when companies with identical prospects are compared, the P/E ratio itself is subject to problems, since net income commingles operating and nonoperating items. By contrast, a company can design an accurate multiples analysis that provides valuable insights about itself and its competitors.