Valuation Using Multiples
P.V. Viswanath
Valuation of the Firm
General Foundation
Involves utilizing existing valuations of
'comparable' assets to price a given
asset by working with a common
variable such as earnings, cash flows,
book value or revenues.
Measures relative values and not
intrinsic values.
Assumptions tend to be implicit because
we take existing valuations of
comparables as “correct.”
Earnings multiples
PE ratio (Price per share/Earnings per share)
Current PE ratio: based on current earnings per
share
Forward PE: based on forecasts of next year’s
earnings.
Price/EBITDA
Value of the firm as a multiple of the operating
income or the earnings before interest, taxes,
depreciation and amortization.
Works like a sort of payback ratio
Determinants of PE ratios
Start with a simple model
P0 = DPS1/(k-g), where k is the cost of equity and g is
the growth rate of dividends
P0/E0 = (DPS1/E0)/(k-g)
= (DPS0/E0)(1+g)/(k-g)
= (Payout Ratio)(1+g)/(k-g)
The higher the growth rate, the higher the PE ratio
Keeping the growth rate constant, the higher the
payout ratio, the higher the PE ratio
Obviously, keeping the same growth rate but raising the
payout ratio is only possible if the assets are used more
efficiently, i.e if return on assets is higher. This causes
a higher valuation.
Book/ Replacement Value Multiples
Markets provide asset values through market prices
Accountants provide asset values through accounting
rules and conventions.
The relationship between market value and book
value varies from industry to industry and depends
on various factors.
For example, during a time of inflation, book values
will be much higher than market values. The extent
of this undervaluation will depend on the firms
assets’ exposure to inflation.
Thus, if output prices in an industry move less (more)
with general inflation, the undervaluation will be less
(more) in that industry.
Measured as mkt value of firm/ book value of all
assets.
Determinants of BV multiples
P0 = DPS1/(k-g), where k is the cost of
equity and g is the growth rate of
dividends
Divide both sides by BV of assets and
noting that DPS1/BV0 =
(DPS1/EPS1)x(EPS1/BV0), we get
P0/BV0 = (DPS1/EPS1)x(EPS1/BV0)/(k-g),
= (Payout ratio)(1+g)(ROE)/(k-g)
Determinants of BV multiples
Payout Ratio – the higher the payout
ratio, the higher the multiple
Growth Rate: the higher the growth
rate in earnings, the higher the
multiple.
ROE: the higher the ROE, the higher
the multiple.
Cost of equity: the lower the cost of
equity, the lower the multiple.
Revenue Multiples
Earnings and book values are subject to
accounting rules; revenue determinations are
less so.
Comparisons can be made even if accounting
rules for comparables vary.
Can be measured as
share price/sales per share or
Firm value/sales
Varies across sectors
Depends on profit margins
Determinants of Revenue Ratios
P0 = DPS1/(k-g), where k is the cost of equity
and g is the growth rate of dividends
Using similar identities as before, we get
P0/Sales = (Profit Margin)(Payout Ratio)(1+g)/(k-g)
The higher the profit margin and the higher
the growth rate, the higher the P/Sales ratio.
Again, we can conclude a higher payout ratio
implies a higher P/Sales ratio only if we
assume that the growth rate will not be
negatively affected. This will only happen if
the ROA is higher.
Marketing Strategy
Dupont Analysis tells us that firms have
to choose between a high margin/low
volume and a low margin/high volume
strategy.
Clearly, the first strategy will yield a
higher Price/Revenue ratio.
This can be used to value a brand name.
Thus the value of the brand equals
[(P/Sales)brand - (P/Sales)nobrand]xSalesbrand
Profit Margins and P/Sales
Higher Profit Margins imply higher
Price/Sales ratios, ceteris paribus
Hence in using industry Price/Sales
ratios, we need to adjust for differences
in profit margins.
Porter Analysis could be used to predict
differences in margins, although this
may simply be a difference in marketing
strategy, as well.
Using Regression with ratios
We have seen that PE ratios depend on growth rates,
payout ratios and cost of equity
So if it’s possible to find comparables with the same
growth rates, payout ratios and cost of equity, the
average PE ratio of the comparables could be used to
value the target firm.
What if the factors are not exactly the same?
How about regressing PE ratio on growth rate,
payout ratio, ROE and beta?
Can we use this relationship to estimate the PE ratio
for the target firm?
Maybe, but we have to keep in mind that the true
underlying relationship may not be linear!
Similarly, we could think of regressing P/Sales on
profit margins.
PEG Ratio
This is the ratio of the PE to the growth rate; if the
PE is 15 and the growth rate is 7.5%, the PEG is 2.
The belief is that stocks with a PEG>1 are overvalued
and PEG<1 are undervalued.
Since this is an equity multiple, the growth rate
should be the growth in EPS, not op inc.
If the growth rate used is the forecasted growth over
the next year, then the PE ratio should be based on
current earnings.
When comparing across firms, the growth rate
estimate for all firms should be over the same time
period, e.g. forecasted 5-year growth rates.
Fundamentals don’t support the traditional
interpretation of the PEG.
Enterprise Value to EBITDA
EV/EBITDA = (MV Equity + MV Debt –
Cash)/EBITDA
EBITDA is Earnings before Interest income
as well as interest paid, before taxes,
depreciation and amortization.
This is a firm-level multiple, which is why
we add back interest paid
Interest income is subtracted out because
the idea is to look at operating income –
interest income may not be part of the
firm’s core operations.
Enterprise Value to EBITDA
Once we exclude interest income, we
also exclude cash and cash equivalents
from the numerator. Once the enterprise
value is computed, we add back cash
and cash equivalents to get a value of
the entire firm.
If a firm has minority holdings, the ratio
may be overstated because income from
these holdings is not included in the
operating income of the firm, while the
value of the equity interest is included in
the numerator.
Determinants of EV/EBITDA
FCFF = EBIT(1-t) – (Capex - DA
+DNoncash WC)
= (EBITDA-DA)(1-t) – Reinvestment
= EBITDA(1-t) – DA(1-t) – Reinv
Reinvestment = Capex - DA
+DNoncash WC
Since V0 = FCFF1/(WACC–g), we get:
V0

EBITDA
(1  t )
EBIT
Re investment

EBITDA
EBITDA
WACC  g
Factors in high EV/EBITDA
A low marginal tax rate: A smaller tax bite
Higher EBIT as a proportion of EBITDA: the
EBIT portion of EBITDA obviously has
greater value.
Lower reinvestment needs as a percentage
of EBITDA: implies higher ROA
Lower cost of capital: lower discount rate
Higher expected growth: higher future
FCFF
When to use an EBITDA Multiple
Used for firms in industries with high
depreciation, where EBITDA is a better
measure of operating cashflow than
EBIT or Net Income.
When the firms being compared have
different depreciation methods, using
an EBITDA multiple keeps them
comparable as opposed to an income
multiple.
ROA and ROE
In general, firm value multiples depend
positively on ROA, while stock value multiples
depend positively on ROE.
The factors affecting a firm’s ability to have a
higher ROA/ROE can be seen from Porter’s
Five Forces model:
Barriers to entry
Weak Buyers
Weak Sellers
Low Threat of substitutes
Market power relative to competitors
ROE, ROA and ratios
A firm with a high (low) ROA/ROE and a low
Price/Book ratio is likely to be undervalued
(overvalued).
Thus, if we regress P/B on ROE, firms with very
high residuals may be overvalued, while those
with very negative residuals are likely to be
undervalued.
This could be used as a screening device.
Of course, the ROE used in this analysis should
be forward looking, else the results may be
misleading.
P/B as a proxy for risk
We are implicitly keeping everything else
constant; thus it’s better to do this analysis
on firms in the same industry.
Else we might be mistaking riskier firms
for undervalued firms.
Fama and French find evidence that a high
P/B ratio is a proxy for risk.
They find that high P/B stocks earn
consistently more than low P/B stocks.
Sector specific multiples
Sometimes there are clear drivers in a given
industry.
In this case, specific multiples may be used in
that industry.
For example, in subscription-based firms,
value per subscriber could be used.
For retailers, value per customer may be
used.
For internet portals, value per site visitor
could be used.
Airlines? Wireless cos? Home improvement
firms?