Learning Outcomes
After reading this article, you will be able to apply market multiples and sector benchmark methods to value businesses for ACCA AFM purposes. You will understand how to select and adjust suitable P/E ratios and other multiples, evaluate when sector benchmarks are appropriate, identify potential pitfalls and limitations, and justify your calculations in exam scenarios.
ACCA Advanced Financial Management (AFM) Syllabus
For ACCA Advanced Financial Management (AFM), you are required to understand how to use market multiples and sector benchmarks as part of business valuation, particularly in acquisition and investment contexts. This article focuses on the following syllabus areas:
- Apply market-based valuation models, including the use of P/E multiples and sector benchmarks
- Identify appropriate proxy companies or sector averages for valuation purposes
- Adjust market multiples to reflect differences in size, risk, liquidity, and control
- Evaluate the strengths and weaknesses of market multiple and sector benchmark valuation approaches
- Advise on interpreting and presenting multiples-based valuations in exam settings
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What does a price-earnings (P/E) ratio represent in the context of business valuation?
- When might a sector benchmark P/E require adjustment before use in an acquisition valuation?
- True or false? The market price of a listed company always reflects its fair value for minority shareholders.
- List two main limitations of using sector benchmarks for business valuation.
Introduction
Valuing a business using market data is a frequent ACCA AFM requirement, especially in acquisition scenarios. Market multiple approaches—most commonly the price-earnings (P/E) ratio—use the relationship between market value and financial metrics from comparable companies or sector averages to estimate the target’s value. These methods offer simplicity and speed, but require careful selection and adjustment of benchmarks to be reliable. Candidates must understand how these multiples work, how to handle control, size, and risk differences, and how to explain the limitations of such approaches in exams.
MARKET MULTIPLES AND SECTOR BENCHMARKS
Market multiple valuation is based on comparing the target business to others in the market using ratios relevant to value.
Price-Earnings (P/E) Ratio
The P/E ratio is the most widely used market multiple in both practice and exams. This ratio expresses the market value of equity relative to the company’s post-tax earnings.
Key Term: Price-earnings (P/E) ratio
The ratio of a company's market price per share to its earnings per share, used to express how much the market is willing to pay for current earnings.
To value a business using a P/E multiple:
- Select a relevant P/E ratio (from a similar company or sector average)
- Multiply the maintainable post-tax earnings by this P/E
This gives an estimate of equity value. For listed companies, use the share price and number of shares to find the P/E; for unlisted companies, a comparable (proxy) benchmark is required.
Key Term: Proxy benchmark
A comparable company or sector metric used as a reference for valuing another business, selected for its similar characteristics.
Market Value, Minority and Control
P/E ratios derived from listed share prices reflect the value of minority shareholdings (i.e., shares that do not carry control). When estimating the value of a controlling stake, especially in unlisted companies, an upward adjustment (control premium) may be needed.
Choosing and Adjusting Sector Benchmarks
Selecting an appropriate benchmark is critical for market multiple valuations. Consider:
- Similarity in size, risk, growth, business model, and sector
- Whether to use a single company as proxy or the sector average
- Adjustments if the target is smaller, less liquid, or riskier (i.e., use a lower P/E)
- Caution with companies operating across multiple sectors
Key Term: Sector benchmark
An average value (e.g., P/E) calculated for a defined industry or sector, used to compare or value companies in that group.
Worked Example 1.1
A software company has after-tax earnings of $4 million. Publicly listed software firms of similar size trade on average at a P/E of 10, while large multi-national software groups have P/Es above 18.
Question: Which P/E would be more appropriate for valuing this company—10 or 18? What value would this suggest?
Answer:
A P/E of 10 is more appropriate, reflecting companies of similar size and risk. Estimated value: $4 million × 10 = $40 million.
Applying Other Market Multiples
Other common multiples include:
- EV/EBITDA (enterprise value/earnings before interest, tax, depreciation, and amortisation), helpful for capital-intensive groups
- Price-to-book, useful for asset-heavy businesses
- Price-to-sales, sometimes applied to early-stage or loss-making businesses
However, the methodological principles and limitations for these are similar to those for P/E ratios.
Interpreting Results and Making Adjustments
- Use maintainable (recurring) earnings as the base, excluding one-off gains or losses
- Clarify if you are using historic or forecast earnings and match P/E accordingly
- Adjust for control premiums, size, liquidity, and risk as appropriate
- Consider recent transaction multiples if available
Worked Example 1.2
A food manufacturing business reports after-tax profits of $6 million. The sector's average P/E is 12, but similar-sized local acquisitions have closed at P/Es between 9 and 11.
Question: What valuation range is sensible, and should the exam answer use the sector average or the recent local transaction multiples?
Answer:
It is safer to use the lower range of transaction multiples for a likely sale—$6 million × 9 = $54 million, to $6 million × 11 = $66 million. The sector average of 12 may overstate the value unless strong justification exists.
Strengths and Weaknesses of Market Multiple Valuation
Advantages:
- Fast and easy to use
- Relies on observable, external market data
- Practical for benchmarking and cross-checking other valuation methods
Limitations:
- Sensitive to market sentiment and possible mispricing
- Ignores company-specific factors (unique risks, assets, growth prospects)
- Proxy or sector may not be truly comparable
- Adjustments for liquidity, size, control are subjective and easily overlooked
Worked Example 1.3
An unquoted engineering firm has recurring net profits of $2 million. The most similar listed company trades at a P/E of 13, but has stronger growth prospects. The sector average P/E is 11. Unlisted local acquisitions have been at a P/E of 9.
Question: Which multiple(s) should be used and how should they be justified?
Answer:
For an unquoted, average-growth business, using the local acquisition range (9) is justifiable. $2 million × 9 = $18 million. Reference to the sector average and listed company multiple can support sensitivity analysis.
Exam Warning
In ACCA AFM exams, using a quoted sector P/E without adjusting for size, growth, or liquidity—especially for unlisted targets—risks losing accuracy marks. Always justify your benchmark choice and explain limitations.
Revision Tip
When answering a market multiple valuation question, always combine your calculation with a brief discussion justifying the benchmark chosen and outlining any assumptions or shortcomings. Calculation alone does not earn full marks.
Summary
Market multiples, especially P/E ratios, provide a quick indication of value but must be handled cautiously. Selecting suitable sector benchmarks or proxies, applying required adjustments, and understanding limitations are all essential for credible, exam-quality answers.
Key Point Checklist
This article has covered the following key knowledge points:
- Understand and apply P/E ratios and other market multiples in business valuation
- Identify and select appropriate proxy company or sector benchmark multiples
- Adjust multiples for size, control, risk, and liquidity where necessary
- Recognise the limitations and potential pitfalls of market multiple and sector benchmark methods
- Present calculations with supporting discussion and justified assumptions
Key Terms and Concepts
- Price-earnings (P/E) ratio
- Proxy benchmark
- Sector benchmark