Valuation Using Multiples

Chapter

11

Valuation Using Multiples

Chapter Introduction and objectives

In addition to DCF analysis analysts and investors commonly use valuation multiples to come up with the "relative value" of a company. That is, valuation multiples are used to estimate relative under or over valuation. This chapter provides an overview of some of the popular multiples.

This chapter has the following objectives:

 Discuss valuation multiples like P/E, P/B, PEG etc

 Highlight the limitations of multiples

 Discuss the use of yield based measures in constructing investment strategies

Introduction

In the last chapter we demonstrated how an analyst can estimate the intrinsic value of a firm using Discounted Cash Flow methods like the Free Cash Flow to Firm approach, the Adjusted Present Value method, and the Capital Cash flow methods. Quite often analysts are also interested in knowing whether a stock is over or under valued vis-à-vis the industry or some peer group. The objective of relative valuation is to find out whether a stock is relatively over or under valued but not in an absolute sense. That is, it is quite possible for a stock to be relatively undervalued compared to some benchmarks but over valued when compared to its own intrinsic value as estimated using the DCF methodology.

Price multiples are a useful way to compare the valuation of a stock over time, against "comparable companies" or the market as a whole. These multiples are a ratio of the stock's current market capitalization to one of its underlying accounting fundamentals such as book value (total owners' equity), sales or net income. Because investors are usually more familiar with share price rather than market capitalization (share price x shares outstanding) the accounting fundamentals are often converted to a per-share basis when using price multiples. Ratios are very popular with investors because they can be calculated easily, and they are readily available from most financial Web sites and newspapers.

While valuation ratios have become ubiquitous, it's important to recognize their strengths and weaknesses Valuation ratios are handy tools to have at your disposal for a quick-and-dirty analysis, but they all require a lot of context to be useful.

The most common price multiples are:

 Price to earnings (P/E) = (Share price)/(Earnings per share). Since earnings are meant to approximate the money available to shareholders, the P/E ratio expresses how much the investor pays for each dollar of earnings. This is the most frequently used price multiple.

 Price to book value [P/B] = (share price)/(book value per share). This compares the value of the firm today with the capital provided to the company over time.

 Price to sales (P/S) = (share price)/(sales per share). This ratio can be useful for valuing cyclical companies where earnings tend to be more volatile than sales, or situations in which a firm temporarily has little or no earnings.

Exhibit 11-1 presents some commonly used multiples.

A high multiple indicates that the market is wiling to pay a high price relative to the underlying fundamental value such as earnings. A company may trade at a high multiple because it has high growth prospects and future earnings are expected to be higher than past earnings. A low multiple indicates that that the stock is not valued highly - perhaps it has low growth prospects, high risk or is simply undervalued by the market. Value investors tend to search for companies trading at lower multiples than peer companies.

Identifying comparable companies

The first step in the application of multiples is to select a set of comparable firms. In any industry group a firm would have many peer companies. How should one select a comparable firm? In other words, what makes two firms comparable? To answer this question one has to look at the source of risk and return for the two companies in question. Companies may be matched on the basis of several characteristics like size, leverage etc. It is important to understand the criterion of comparability differs from one multiple to another. For example, when one is using the price to earnings multiple, leverage is crucial because two firms may be similar in all respect except the debt ratio. A firm with high debt ratio would have fewer shares, higher EPS and lower P/E multiple, other things remaining constant.

The normal practice in the US is to identify all companies with the same 3 digit SIC code with available data to estimate multiples . If fewer than five companies are identified one may relax the industry requirement to companies with the same 2 digit SIC code and so on.

Exhibit 11-1: Examples of Multiples

Market Capitalization divided by Stock Price divided by

Net Income Earnings per Share

Net Cash flow Cash Flow per share

EBIT Book Value Per share

Sales per share

Enterprise Value divided by

EBITDA

EBIT

Total Assets

Net Fixed Assets

The P/E Multiple

P/E is the most popular valuation ratio used by investors. It is the ratio of a stock's market price divided by the earnings per share for the most recent four quarters. One characteristic of P/E is that accounting earnings are a much better proxy for cash flow (used for valuation) than sales. Moreover, earnings per share results and estimates about the future are easily available from many sources.

P/E = Market Price of share / Earnings per share

The P/E ratio shows the number of years' earnings per share (EPS) contained in the current share price. In other words, it shows the number of years at current earnings needed to cover the current share price. The P/E ratio measures how much investors are willing to pay for every dollar