In which scenario is multiple contraction often observed?

Multiple contraction is a phenomenon that often occurs in markets where companies face diminished valuations as their growth prospects weaken or become limited due to external conditions. In this case, large companies with fewer potential buyers are particularly susceptible to multiple contraction. When there are fewer buyers, the competition diminishes, leading to a decrease in demand for the company's stock. This reduced demand typically results in lower price-to-earnings (P/E) ratios, thus causing a contraction in the multiples at which these companies are valued.

When evaluating this situation, it's crucial to recognize that large companies often depend on a broader market for mergers and acquisitions or investment opportunities. If there are limited potential buyers, perhaps due to economic downturns or industry-specific challenges, investors may perceive increased risk or uncertainty regarding future growth. As such, the lack of competitive interest can compel investors to adjust their expectations, resulting in a downward adjustment of valuation multiples.

In contrast, scenarios involving small-sized companies in expansion may suggest growth potential and attract investors, while companies attracting multiple bids would typically see an increase in valuations due to heightened competition among buyers. Companies in a competitive environment may maintain stable valuations due to ongoing rivalry and innovation driving performance. Hence, the scenario involving large companies with fewer potential buyers is most aligned with