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Chapter 14Using Multiples to Triangulate Results

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Why Use Multiples?

Multiples can assist in:

1. Testing the plausibility of forecasted cash flows.

2. Identifying disparities between a company’s

performance and those of its competitors.

3. Identifying which companies the market

believes are strategically positioned to create

more value than other industry players.

Multiples analysis is useful only when performed accurately. Poorly

performed multiples analysis can lead to misleading conclusions.

• A careful multiples analysis—comparing a company’s multiples versus those

of comparable companies—can be useful in improving cash flow forecasts

and testing the credibility of DCF-based valuations.

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What Are Multiples?

• Multiples such as the enterprise-value-to-revenue ratio and the enterprise-value-to-

EBITA ratio are used to compare the relative valuations of companies. Multiples

normalize market values by revenues, profits, asset values, or nonfinancial statistics.

Specialty Retail: Trading Multiples, December 2009

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$ million Debt and Gross NetMarket debt enterprise enterprise

Ticker Company capitalization equivalents value value Revenue EBITDA EBITAAZO AutoZone 7,915 2,783 10,698 10,535 1.5 7.5 8.5BBBY Bed Bath & Beyond 10,368 − 10,368 9,477 1.3 9.5 11.3BBY Best Buy 16,953 2,476 19,429 18,525 0.4 6.0 7.4HD Home Depot 49,601 11,434 61,035 60,510 0.9 9.2 13.0LOW Lowe's 34,814 6,060 40,874 39,960 0.8 8.3 12.2PETM Petsmart 3,386 634 4,019 3,867 0.7 6.5 10.4SHW Sherwin-Williams 7,029 1,099 8,128 8,044 1.1 9.5 11.4SPLS Staples 18,054 3,518 21,572 20,938 0.9 10.1 13.2

Mean 1.0 8.3 10.9Median 0.9 8.8 11.4

Deviation (percent)1 38.1% 17.3% 18.2%

1Deviation = Standard deviation/median.

1-year forward multiples (times)

Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:

1. Use the right multiple. For most analyses, enterprise value to EBITA is the

best multiple for comparing valuations across companies. Although the price-to-

earnings (P/E) ratio is widely used, it is distorted by capital structure and

nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you

exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.

Refine the sample to peers that have similar outlooks for long-term growth and

return on invested capital (ROIC).

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Enterprise Value to EBITA

g(1 T) 1

Value ROICEBITA WACC g

g

g

WACC

ROIC1NOPLAT

Value

gEBITA(1-T) 1

ROICValue

WACC g

Substitute EBITA(1 − T)

for NOPLAT.

Start with the key value

driver formula.

Divide both sides by EBITA

to develop the enterprise

value multiple.

When computing and comparing industry multiples, always start with

enterprise value to EBITA. It tells more about a company’s value than

any other multiple. To see why, consider the key value driver formula

developed earlier:

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Enterprise Value to EBITA

g

gT

WACC

ROIC1)(1

EBIT

Value

• Let’s use the formula to predict the enterprise-value-to-EBITA multiple for a

company with the following financial characteristics:

• Consider a company growing at 5 percent per year and generating a 15

percent return on invested capital. If the company has an operating tax rate

at 30 percent and a 9 percent cost of capital, what multiple of EBITA should

it trade at?

7.11%5%915%5%

1)30.(1

EBIT

Value

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Distribution of EV to EBITA

• The majority of companies fall between 7 times and 11 times

EBITA. If the company or industry you are examining falls outside

this range, make sure to identify the reason.

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Number of observations

1 Excluding financial institutions, real estate companies, and companies with extremely small or negative EBITA.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Enterprise value to EBITA

S&P 5001: Distribution of Enterprise Value to EBITA, December 2009

Why EV to EBITA and Not Price to Earnings?

• A cross-company multiples analysis should highlight differences in performance, such

as differences in ROIC and growth, not differences in capital structure.

• Although no multiple is completely independent of capital structure, an enterprise value

multiple is less susceptible to distortions caused by the company’s debt-to-equity

choice. The multiple is calculated as follows:

EBITA

EquityMVDebt MV

EBITA

ValueEnterprise

• Consider a company that swaps debt for equity (i.e., raises debt to repurchase equity).

• EBITA is computed pre-interest, so it remains unchanged as debt is swapped

for equity.

• Swapping debt for equity will keep the numerator unchanged as well. Note,

however, that EV may change due to the second-order effects of signaling,

increased tax shields, or higher distress costs.

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Why EV to EBITA and Not Price to Earnings?

• To show how capital structure distorts the P/E, consider four companies, named A

through D. Companies A and B trade at 10 times enterprise value to EBITA, and

Companies C and D trade at 25 times enterprise value to EBITA.

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P/E Multiple Distorted by Capital Structure

Since Companies A and

B trade at low enterprise

value multiples, the

price-to-earnings ratio

drops for the company

with higher leverage.

Since Companies C and

D trade at high

enterprise value

multiples, the price-to-

earnings ratio increases

for the company with

higher leverage.

$ million

Income statement Company A Company B Company C Company DEBITA 100 100 100 100Interest expense − (20) − (25)Earnings before taxes 100 80 100 75

Taxes (40) (32) (40) (30)Net income 60 48 60 45

Market valuesDebt − 400 − 500Equity 1,000 600 2,500 2,000

Enterprise value (EV) 1,000 1,000 2,500 2,500

Multiples (times)EV to EBITA 10.0 10.0 25.0 25.0Price to earnings 16.7 12.5 41.7 44.4

Why EBITA and Not EBITDA?

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• Consider three companies, named A,

B, and C. Each company generates the

same level of underlying operating

profitability; they differ only in size.

• Since all three companies generate the

same level of operating performance,

they trade at identical multiples before

the acquisition of B by A.

• Following the acquisition, however,

amortization expense causes EBIT to

drop for the combined company and

the enterprise value-to-EBIT multiple to

rise.

Enterprise-Value-to-EBIT Multiple Distorted by Acquisition Accounting

$ million

EBIT Company A Company B Company C Company A+B Company CRevenues 375 125 500 500 500Cost of sales (150) (50) (200) (200) (200)Depreciation (75) (25) (100) (100) (100)Amortization − − − (25) −EBIT 150 50 200 175 200

Invested capitalOrganic capital 750 250 1,000 1,000 1,000Acquired intangibles − − − 125 −Invested capital 750 250 1,000 1,125 1,000

Enterprise value 1,125 375 1,500 1,500 1,500

Multiples (times)EV to EBITA 5.0 5.0 5.0 5.0 5.0EV to EBIT 7.5 7.5 7.5 8.6 7.5

After A acquires BBefore acquisition

Why EBITA and Not EBITDA?

Company B outsources

manufacturing to another

company.

Incurs depreciation cost

indirectly through an

increase in the cost of

raw material.

Company A

manufactures

products with its

own equipment.

Incurs depreciation

cost directly.

• Many financial analysts use multiples of EBITDA, rather than EBITA, because

depreciation is a noncash expense, reflecting sunk costs, not future investment.

• But EBITDA multiples have their own drawbacks. To see this, consider two companies,

which differ only in outsourcing policies. Because they produce identical products at

the same costs, their valuations are identical ($3,000).

• What is each companies EV-to-EBITDA multiple and why are they different?

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$ million

Income statement Company A Company BRevenues 1,000 1,000Raw materials (100) (250)Operating costs (400) (400)EBITDA 500 350

Depreciation (200) (50)EBITA 300 300

Operating taxes (90) (90)NOPLAT 210 210

Use Forward-Looking Multiples

• When building multiples, the denominator should use a forecast of

profits, rather than historical profits.

– Unlike backward-looking multiples, forward-looking multiples are

consistent with the principles of valuation—in particular, that a

company’s value equals the present value of future cash flows,

not sunk costs.

– Second, forward-looking earnings are typically normalized,

meaning they better reflect long-term cash flows by avoiding

one-time past charges.

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Use Forward-Looking Multiples

• To build a forward-looking multiple, choose a forecast year for EBITA that best represents

the long-term prospects of the business.

• In periods of stable growth and profitability, next year’s estimate will suffice. For

companies generating extraordinary earnings (either too high or too low) or for

companies whose performance is expected to change, use projections further out.

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Pharmaceuticals: Backward- and Forward-Looking Multiples, December 2007

Whereas historical

P/E ratios across

pharmaceutical

companies show

significant variation…

Price/earnings Enterprise value/EBITA2007 net income Estimated 2008 EBITA1 Estimated 2012 EBITA1

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Merck

Bristol-Myers Squibb

Abbott

Eli Lilly

Novartis

Pfizer

Johnson & Johnson

Sanofi-Aventis

GlaxoSmithKline

Wyeth

AstraZeneca

Schering-Plough N/A2

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the forward-looking

EV-to-EBITA

multiples are nearly

identical.

1Consensus analyst forecast.2Schering-Plough recorded loss in 2007, so no multiple is reported.

Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:

1. Use the right multiple. For most analyses, enterprise value to EBITA is the

best multiple for comparing valuations across companies. Although the price-to-

earnings (P/E) ratio is widely used, it is distorted by capital structure and

nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you

exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.

Refine the sample to peers that have similar outlooks for long-term growth and

return on invested capital (ROIC).

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Calculate the Multiple in a Consistent Manner

• There is only one approach to building an enterprise-value-to-EBITA

multiple that is theoretically consistent. Enterprise value must include all

investor capital but only the portion of value attributable to assets that

generate EBITA.

• Including value in the numerator without including its corresponding income

in the denominator will systematically distort the multiple upward.

• Conversely, failing to recognize a source of investor capital, such as

minority interest, will understate the numerator, biasing the multiple

downward. If the company holds nonoperating assets or has claims on

enterprise value other than debt and equity, these must be accounted for.

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Consistency: Nonoperating Assets

• Company A holds only core operating

assets and is financed by traditional

debt and equity.

• Company B operates a similar

business to Company A, but it also

owns $100 million in excess cash and

a minority stake in a nonconsolidated

subsidiary, valued at $200 million.

• Since excess cash and

nonconsolidated subsidiaries do not

contribute to EBITA, they should not

be included in the numerator of an

EV-to-EBITA multiple.

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Enterprise Value Multiples and Complex Ownership

Partial income statementCompany A Company B

EBITA 100 100Interest income − 4Interest expense (18) (18)Earnings before taxes 82 86

Gross enterprise value

Value of core operations 900 900Excess cash − 100Nonconsolidated subsidiaries − 200Gross enterprise value 900 1,200

Debt 300 300Minority interest − −Market value of equity 600 900Gross enterprise value 900 1,200

Consistency: Include All Financial Claims

• For Company C, outside investors hold

a minority stake in a consolidated

subsidiary.

• Since the minority stake’s value is

supported by EBITA, it must be included

in the enterprise value calculation.

Otherwise, the EV-to-EBITA multiple will

be biased downward.

• The numerator should include not just

debt and equity, but also minority

interest, the value of unfunded pension

liabilities, and the value of employee

grants outstanding.

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Enterprise Value Multiples and Complex Ownership

Partial income statementCompany A Company C

EBITA 100 100Interest income − −Interest expense (18) (18)Earnings before taxes 82 82

Gross enterprise value

Value of core operations 900 900Excess cash − −Nonconsolidated subsidiaries − −Gross enterprise value 900 900

Debt 300 300Minority interest − 100Market value of equity 600 500Gross enterprise value 900 900

Advanced Adjustments

For companies with rental expense or pension assets, two additional

adjustments can be made.

1. The use of operating leases leads to artificially low enterprise value (missing debt)

and EBITA (lease interest is subtracted pre-EBITA). Although operating leases affect

both the numerator and denominator in the same direction, each adjustment is of a

different magnitude.

Interest Lease ImpliedEBITA

EquityLeases) ngPV(OperatiDebt

EBITA

Value Enterprise

2. To adjust enterprise value for pensions, add the present value of unfunded pension

liabilities to debt plus equity. To remove gains and losses related to plan assets, start

with EBITA, add back pension expense, and deduct any service costs.

Enterprise Value Debt + PV(Unfunded Pensions) + Equity=

EBITA EBITA + Pension Expense - ServiceCost

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Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:

1. Use the right multiple. For most analyses, enterprise value to EBITA is the

best multiple for comparing valuations across companies. Although the price-to-

earnings (P/E) ratio is widely used, it is distorted by capital structure and

nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you

exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.

Refine the sample to peers that have similar outlooks for long-term growth and

return on invested capital (ROIC).

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Selecting a Robust Peer Group

To create and analyze an appropriate peer group:

• Start by examining other companies in the target’s industry. But how do you

define an industry?

• Potential resources include the annual report, the company’s Standard

Industry Classification (SIC), or its Global Industry Classification (GIC).

• Once a preliminary screen is conducted, the real digging begins. You must

answer a series of strategic questions.

• Why are the multiples different across the peer group?

• Do certain companies in the group have superior products, better

access to customers, recurring revenues, or economies of scale?

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Expect Variation Even within an Industry

• As demonstrated earlier, the enterprise-value-to-EBITA multiple is

driven by growth, ROIC, the operating tax rate, and the company’s

cost of capital.

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g(1 T) 1

Value ROICEBITA WACC g

Peers in the same industry will have similar risk profiles

and consequently similar costs of capital.

Since growth will vary across companies, so

will their enterprise value multiples.

Be careful comparing across countries. Different tax rates

will drive differences in multiples.

Companies with higher ROICs will need less

capital to grow. This will drive higher multiples.

ROIC and Growth Drive Variation

• The companies below fall into three performance buckets that align with different

multiples. The companies with the lowest margins and low growth expectations had

multiples of 7×. The companies with low growth but high margins had multiples of 9×.

Finally, the companies with high growth and high margins had multiples of 11× to 13×.

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Factors for Choosing a Peer Group

Valuation multiples Consensus projected financial performance

Enterprise value/ Sales growth, EBITA margin,EBITA 2010–2013 2010 Performance

(percent) (percent) characteristics

Low growth,low margin

Low growth,high margin

High growth,high margin

7

7

9

9

11

13

Company A

Company B

Company C

Company D

Company E

Company F

5

3

4

3

7

8

12

6

21

24

18

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Closing Thoughts

A multiples analysis that is careful and well reasoned not only will provide a useful check of

your discounted cash flow (DCF) forecasts but also will provide critical insights into what

drives value in a given industry. A few closing thoughts about multiples:

1. Similar to DCF, enterprise value multiples are driven by the key value drivers, return

on invested capital and growth. A company with good prospects for profitability and

growth should trade at a higher multiple than its peers.

2. A well-designed multiples analysis will focus on operations, will use forecasted

profits (versus historical profits), and will concentrate on a peer group with similar

prospects.

• P/E ratios are problematic, as they commingle operating, nonoperating, and

financing activities, which leads to misused and misapplied multiples.

3. In limited situations, alternative multiples can provide useful insights. Common

alternatives include the price-to-sales ratio, the adjusted price-earnings growth

(PEG) ratio, and multiples based on nonfinancial (operational) data.

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