Valuation using multiples

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In economics, valuation using multiples, or “relative valuation”, is a process that consists of:

Economics Social science that analyzes the production, distribution, and consumption of goods and services

Economics is the social science that studies the production, distribution, and consumption of goods and services.

Relative valuation also called valuation using multiples is the notion of comparing the price of an asset to the market value of similar assets. In the field of securities investment, the idea has led to important practical tools, which could presumably spot pricing anomalies. These tools have subsequently become instrumental in enabling analysts and investors to make vital decisions on asset allocation.

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Asset economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

Market value or OMV is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may or may not differ in some circumstances.

Multiples analysis is one of the oldest methods of analysis. It was well understood in the 1800s and widely used by U.S. courts during the 20th century, although it has recently declined as Discounted Cash Flow and more direct market-based methods have become more popular.

Valuation multiples

A valuation multiple [1] is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – whether earnings, cash flow or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value.

Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before interest, taxes, depreciation, and amortization.

Cash flow movement of money into or out of a business, project, or financial product

A cash flow is a real or virtual movement of money:

In stock trading, one of the most widely used multiples is the price-earnings ratio (P/E ratio or PER) which is popular in part due to its wide availability and to the importance ascribed to earnings per share as a value driver. However, the usefulness of P/E ratios is lessened by the fact that earnings per share is subject to distortions from differences in accounting rules and capital structures between companies.

Earnings per share EPS

Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company.

Other commonly used multiples are based on the enterprise value of a company, such as (EV/EBITDA, EV/EBIT, EV/NOPAT). These multiples reveal the rating of a business independently of its capital structure, and are of particular interest in mergers, acquisitions and transactions on private companies.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

Earnings before interest and taxes measure of a firms profit

In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses except interest expenses and income tax expenses.

In corporate finance, net operating profit after tax (NOPAT) is a company's after-tax operating profit for all investors, including shareholders and debt holders. NOPAT is used by analysts and investors as a precise and accurate measurement of profitability to compare a company's financial results across its history and against competitors.

When calculating NOPAT, one removes Interest Expense and the effects of other non-operating activities from Net Income to arrive at a value that approximates the value of a firm's annual earnings. NOPAT is precisely calculated as:

Not all multiples are based on earnings or cash flow drivers. The price-to-book ratio (P/B) is a commonly used benchmark comparing market value to the accounting book value of the firm's assets. The price/sales ratio and EV/sales ratios measure value relative to sales. These multiples must be used with caution as both sales and book values are less likely to be value drivers than earnings.

Less commonly, valuation multiples may be based on non-financial industry-specific value drivers, such as enterprise value / number of subscribers for cable or telecoms businesses or enterprise value / audience numbers for a broadcasting company. In real estate valuations, the sales comparison approach often makes use of valuation multiples based on the surface areas of the properties being valued.

Peer group

A peer group is a set of companies or assets which are selected as being sufficiently comparable to the company or assets being valued (usually by virtue of being in the same industry or by having similar characteristics in terms of earnings growth and/or return on investment).

In practice, no two businesses are alike, and analysts will often make adjustment to the observed multiples in order to attempt to harmonize the data into more comparable format. These adjustments may be based on a number of factors, including:

These adjustments can involve the use of regression analysis against different potential value drivers and are used to test correlations between the different value drivers.

When the peer group consists of public quoted companies, this type of valuation is also often described as comparable company analysis (or "comps", "peer group analysis", "equity comps", " trading comps", or "public market multiples"). When the peer group consists of companies or assets that have been acquired in mergers or acquisitions, this type of valuation is described as precedent transaction analysis (or "transaction comps", "deal comps", or "private market multiples").

Advantages/disadvantages of multiples

Disadvantages

There are a number of criticisms levied against multiples, but in the main these can be summarised as:

Advantages

Despite these disadvantages, multiples have several advantages.

These factors, and the existence of wide-ranging comparables, help explain the enduring use of multiples by investors despite the rise of other methods.

Comparison of commonly used valuation multiples

Equity price based multiples

Equity price based multiples are most relevant where investors acquire minority positions in companies. Care should be used when comparing companies with very different capital structures. Different debt levels will affect equity multiples because of the gearing effect of debt. In addition, equity multiples will not explicitly take into account balance sheet risk.

MultipleDefinitionAdvantagesDisadvantages
P/E ratio Share price / Earnings per share (EPS)

EPS is net income/weighted average no of shares in issue

EPS may be adjusted to eliminate exceptional items (core EPS) and/or outstanding dilutive elements (fully diluted EPS)

  • Most commonly used equity multiple
  • Data availability is high
  • EPS can be subject to differences in accounting policies and manipulation
  • Unless adjusted, can be subject to one-off exceptional items
  • Cannot be used if earnings are negative
Price / cash earningsShare price / earnings per share plus depreciation amortization and changes in non-cash provisions
  • Cash earnings are a rough measure of cash flow
  • Unaffected by differences in accounting for depreciation
  • Incomplete treatment of cash flow
  • Usually used as a supplement to other measures if accounting differences are material
Price / book ratio Share price / book value per share
  • Can be useful where assets are a core driver of earnings such as capital-intensive industries
  • Most widely used in valuing financial companies, such as banks, because banks have to report accurate book values of their loans and deposits, and liquidation value is equal to book value since deposits and loans are liquidated at same value as reported book values.
  • Book values for tangible assets are stated at historical cost, which is not a reliable indicator of economic value
  • Book value for tangible assets can be significantly impacted by differences in accounting policies
PEG ratio Prospective PE ratio / prospective average earnings growth
  • Most suitable when valuing high growth companies
  • Requires credible forecasts of growth
  • Can understate the higher risk associated with many high-growth stocks
Dividend yield Dividend per share / share price
  • Useful for comparing cash returns with types of investments
  • Can be used to establish a floor price for a stock
  • Dependent on distribution policy of the company
  • Yield to investor is subject to differences in taxation between jurisdictions
  • Assumes the dividend is sustainable
Price / SalesShare price / sales per share
  • Easy to calculate
  • Can be applied to loss making firms
  • Less susceptible to accounting differences than other measures
  • Mismatch between nominator and denominator in formula (EV/Sales is a more appropriate measure)
  • Not used except in very broad, quick approximations

Enterprise value based multiples

Enterprise value based multiples are particularly relevant in mergers & acquisitions where the whole of the company’s stock and liabilities are acquired. Certain multiples such as EV/EBITDA are also a useful complements to valuations of minority interests, especially when the P/E ratio is difficult to interpret because of significant differences in capital structures, in accounting policies or in cases where net earnings are negative or low.

MultipleDefinitionAdvantagesDisadvantages
EV/SalesEnterprise value / net sales
  • Least susceptible to accounting differences
  • Remains applicable even when earnings are negative or highly cyclical
  • A crude measure as sales are rarely a direct value driver
EV/EBITDAREnterprise value / Earnings before Interest, Tax, Depreciation & Amortization and Rental Costs
  • Proxy for operating free cash flows
  • Attempts to normalize capital intensity between companies that choose to rent rather than own their core assets
  • Most often used in the transport, hotel and retail industries
  • Rental costs may not be reported and need to be estimated
  • Ignores variations in capital expenditure and depreciation
  • Ignores value creation through tax management
EV/EBITDA Enterprise value / Earnings before Interest, Tax, Depreciation & Amortization. Also excludes movements in non-cash provisions and exceptional items
  • EBITDA is a proxy for free cash flows
  • Probably the most popular of the EV based multiples
  • Unaffected by depreciation policy
  • Ignores variations in capital expenditure and depreciation
  • Ignores potential value creation through tax management
EV/EBIT and EV/EBITAEnterprise value / Earnings before interest and taxes (and Amortisation)
  • Better allows for differences in capital intensiveness compared to EBITDA by incorporating maintenance capital expenditure
  • Susceptible to differences in depreciation policy
  • Ignores potential value creation through tax management
EV/NOPLAT Enterprise value / Net Operating Profit After Adjusted Tax
  • NOPLAT incorporates a number of adjustments to better reflect operating profitability
  • NOPLAT adjustments can be complicated and are not applied consistently by different analysts
EV/opFCFEnterprise value / Operating Free Cash Flow

OpFCF is core EBITDA less estimated normative capital expenditure requirement and estimated normative variation in working capital requirement

  • Better allows for differences in capital intensiveness compared to EBITDA
  • Less susceptible to accounting differences than EBIT
  • Use of estimates allows for smoothing of irregular real capital expenditures
  • Introduces additional subjectivity in estimates of capital expenditure
EV/ Enterprise FCFEnterprise value / Free cash flow

Enterprise FCF is core EBITDA less actual capital expenditure requirement and actual increase in working capital requirement

  • Less subjective than opFCF
  • Better allows for differences in capital intensiveness compared to EBITDA
  • Less susceptible to accounting differences than EBIT
  • Can be volatile and difficult to interpret as capital expenditure is often irregular and “lumpy”
EV/Invested CapitalEnterprise value / Invested capital
  • Can be useful where assets are a core driver of earnings, such as for capital-intensive industries
  • Book values for tangible assets are stated at historical cost, which is not a reliable indicator of economic value
  • Book value for tangible assets can be significantly impacted by differences in accounting policies
EV/Capacity MeasureDepends on industry (e.g. EV/subscribers, EV/production capacity, EV/audience)
  • Not susceptible to accounting differences
  • Remains applicable even when earnings are negative or highly cyclical
  • A crude measure as capacity measures are rarely a direct value driver

Example (discounted forward PE ratio method)

Mathematics

ForMultiples.gif

Condition: Peer company is profitable.

Rf = discount rate during the last forecast year

tf = last year of the forecast period.

C = correction factor

P = current stock Price

NPP = net profit peer company

NPO = net profit of target company after forecast period

S = number of shares

Process data diagram

The following diagram shows an overview of the process of company valuation using multiples. All activities in this model are explained in more detail in section 3: Using the multiples method.

MultiplesPDD.gif

Using the multiples method

Determine forecast period

Determine the year after which the company value is to be known.

Example:

'VirusControl' is an ICT startup that has just finished their business plan. Their goal is to provide professionals with software for simulating virus outbreaks. Their only investor is required to wait for 5 years before making an exit. Therefore, VirusControl is using a forecast period of 5 years.

Identifying peer company

Search the (stock)market for companies most comparable to the target company. From the investor perspective, a peer universe can also contain companies that are not only direct product competitors but are subject to similar cycles, suppliers and other external factors (e.g. a door and a window manufacturer may be considered peers as well).

Important characteristics include: operating margin, company size, products, customer segmentation, growth rate, cash flow, number of employees, etc.

Example:

VirusControl has identified 4 other companies similar to itself.

  • Medical Sim
  • Global Plan
  • Virus Solutions
  • PM Software

Determining correct price earning ratio (P/E)

The price earnings ratio (P/E) of each identified peer company can be calculated as long as they are profitable. The P/E is calculated as:

P/E = Current stock price / (Net profit / Weighted average number of shares)

Particular attention is paid to companies with P/E ratios substantially higher or lower than the peer group. A P/E far below the average can mean (among other reasons) that the true value of a company has not been identified by the market, that the business model is flawed, or that the most recent profits include, for example, substantial one-off items. Companies with P/E ratios substantially different from the peers (the outliers) can be removed or other corrective measures used to avoid this problem.

Example:

P/E ratio of companies similar to VirusControl:

 Current Stock PriceNet profitNumber of Shares P/E
Medical Sim€'16.32 €'1.000.000 1.100.000 17.95
Global Plan€'19.50 €'1.800.000 2.000.000 21.7
Virus Solutions€'6.23 €'3.000.000 10.000.000 20.8
PM Software€'12.97 €'4.000.000 2.000.000 6.5

One company, PM Software, has substantially lower P/E ratio than the others. Further market research shows that PM Software has recently acquired a government contract to supply the military with simulating software for the next three years. Therefore, VirusControl decides to discard this P/E ratio and only use the values of 17.95, 21.7 and 20.8.

Determining future company value

The value of the target company after the forecast period can be calculated by:

Average corrected P/E ratio * net profit at the end of the forecast period.

Example:

VirusControl is expecting a net profit at the end of the fifth year of about €2.2 million. They use the following calculation to determine their future value:

((17.95 + 21.7 + 20.8) / 3) * 2.200.000 = €44.3 million

Determining discount rate / factor

Determine the appropriate discount rate and factor for the last year of the forecast period based on the risk level associated with the target company

Example:

VirusControl has chosen their discount rate very high as their company is potentially very profitable but also very risky. They calculate their discount factor based on five years.

Risk Rate50%
Discount Rate50%
Discount Factor 0.1316

Determining current company value

Calculate the current value of the future company value by multiplying the future business value with the discount factor. This is known as the time value of money.

Example:

VirusControl multiplies their future company value with the discount factor:

44,300,000 * 0.1316 = 5,829,880 The company or equity value of VirusControl: €5.83 million

See also

Related Research Articles

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.

Fundamental analysis analysis of a businesss financial statements

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

Price–earnings ratio the ratio of a companys share price to the companys earnings per share

The price-earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

The 'PEG ratio' is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.

In finance, the terminal value of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.

Intellectual property assets such as patents are the core of many organizations and transactions related to technology. Licenses and assignments of intellectual property rights are common operations in the technology markets, as well as the use of these types of assets as loan security. These uses give rise to the growing importance of financial valuation of intellectual property, since knowing the economic value of patents is a critical factor in order to define their trading conditions.

The following outline is provided as an overview of and topical guide to finance:

In finance, relative value is the attractiveness measured in terms of risk, liquidity, and return of one financial instrument relative to another, or for a given instrument, of one maturity relative to another. The concept arises in economics, business and investment.

A control premium is an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company in order to acquire a controlling share in that company.

Enterprise value/EBITDA is a popular valuation multiple used in the finance industry to measure the value of a company. It is the most widely used valuation multiple based on enterprise value and is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.

The First Chicago Method or Venture Capital Method is a business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach.

Financial ratio characteristic number

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

EV/GCI is an advanced valuation multiple used to compare a company's book value of its assets to their current market value. The ratio is similar to P/B ratio, but EV/GCI is calculated on an EV-basis, taking into account all the company's security-holders.

The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value. The theory's primary use is to estimate the value of a company’s shares. The secondary use is to estimate the cost of capital, as an alternative to e.g. the CAPM. The "clean surplus" is calculated by not including transactions with shareholders when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends.

References

  1. UBS Warburg. "Valuation Multiples: A Primer 2001".
  2. Hughes, David (2012). The Business Value Myth. Canopy Law Books. ASIN   B009XB91CU.