One of the most common questions that I get is why my models use multiples rather than a DCF for valuation. Personally, I believe a lot of people are too focused on DCFs. There's a common perception that professionals use complex DCFs with big finance terms while amateurs do third-grade math to get to a price target. It's not about which is more difficult or complex; it's about which method weighs the inputs appropriately given our certainty on the future of the company.
Why Investors Use Multiples
Before I get into why multiples are used more often, it's important to note that not every company is valued in the same manner. For companies with high visibility into their future free cash flow generation, it might be more relevant to use a DCF. For companies where a lot of the hidden value is locked in their balance sheet, an EV/EBITDA multiple might be more relevant. It depends on the thesis, the business model, and the industry.
With that said, many investors value companies using multiples. Multiples are often times more appropriate than DCFs because they are better suited for companies with a greater degree of future uncertainty, take into account market sentiment (which could also be seen as a bad thing), and are better for short-term views on the stock. As many people can attest, it's hard enough to forecast earnings for the current year. In a DCF, you'll have to forecast 10 years into the future, and most of the company's value will come from that future forecast. In contrast to that, multiples weigh near-term forecasts more heavily since the valuation method only includes your estimate in 1-2 years.
Let's take Apple as an example. Here are tidbits pulled from equity research reports at the major banks after Apple reported their F2Q15 quarter:
Goldman Sachs: Our price target moves to $163 (from $145), which is based on 15X (from 16X, to reflect normalizing growth) our CY16 EPS estimate of $10.88 (vs. CY15 EPS of $9.08 previously).
Credit Suisse: Our target price for Apple is $145. We calculate this by applying a 13.5x multiple to our CY2016 EPS and adding back $12/share of net cash to be returned by the end of FY16.
Jefferies: Over the last three years, AAPL has traded at P/E (NTM) in the range of 9x to 15x (avg. ~12x), and is currently trading at 14x. Our PT of $135 represents P/E of 14x off our FY16 EPS est of $9.51.
Piper Jaffray: We are increasing our price target to $162 From $160. Our revised price target is driven by an increase in EPS. Our price target multiple of 19x 2016E EPS remains unchanged.
You'll find similar methodologies from investors at major buy-side funds. One could browse SumZero's published theses and find that many involve a multiple to arrive at a price target. Put simply, multiples are the framework that investors use to debate and forecast stock prices.
That's not to say that DCFs are not useful. DCFs can provide a sanity check and an alternative perspective on a stock's value. Additionally, for some companies, it might be the preferred valuation method. However, it's not as dominant a valuation method as most people would imagine.