Multiples

Four steps to using multiples 1. Definitional tests

o is EPS LTM or last fiscal year, etc. 2. consistency

o Numerator must be same value as denominator – equity or enterprise 3. Uniformity

o Make sure fiscal year is same for high growth industries, less problem in mature

4. Descriptional testso Median, distribution, etc.

Determinants o Every multiple has risk, growth, and cash flow generating potentialo Firms with lower risk, higher growth, and greater cash flow potetntial

should trade higher Companion variable – variable that dominates explanation for changes in

multiple What is a comparable firm

o One with cash flow characteristics, growth potential, and risk similar to analyzed company

DCF – assume markets make mistakes, that they correct them over time, and that these mistakes can happen across industries and the market

Relative valuation – individual stocks can be mispriced, but market is correct on the whole

P/E Ratio

Differences in P/E for high growth firmso 1. Volatility in earnings per share – growth o 2. Management options

Diluted shares can make differences between diluted and primary EPS diff.

Comparing P/E ratioso Same industry can have firms with different business mixes, risk, and

growth profileso Leads to bias in results if you just apply the average

Regressiono Control explicitly for one or two variables and create a regressiono Use regression equation to predict PE ratios

PEG Ratio

Issueso Still doesn’t consider risk – riskier companies will have lower PEG’s

and look more undervalued

o Firms with lower returns on equity or lower payout ratios will have lower PEG and look more undervalued

o Growth itself is volatile in determining PEG ratios at the extreme ends

EV/EBITDA

Reasons o 1. Compare multiples across firms with different financial leverageo 2. Different depreciation methods cause differences in NI and EBIT

but not EBITDAo 3. Less negative EBITDA companieso Good for companies with firms that require large investments in

infrastructure with long gestation periods – telecom, toll road, airport, construction, etc.

Often used in capital intensive firms with heavy infras investmentso Wrong becasuseo Many of firms tend to have high cap ex to drain cash flowo Good reasons

Depreciation methods vary greatly Bulk of investment in infrastructure has been made already

Book Value multiples

1. Stable intuitive measure of value to be compared to MV 2. If accounting standards are same across firm, it can show signs of over or

under valuation 3. Less firms with negative BV

Private Company valuation

Adjusting for nondiversification – cost of equityo Beta measures the risk added by an investment to a diversified

portfolio Best suited for marginal investors that are diversified

o If owner has all wealth in company – exposed to all risk in firm and market risk

o Total beta = market beta / correlation of stock to index Cost of debt

o Use interest coverage ratio o EBIT / interest

Debt ratioo Use industry average or iterate it based on DCF

Cash flowso Owner salaries and equity case flowso 1. Do not consider salaries for owner-managers – do not distinguish

between dividends and salarieso 2. Intermingling of business and personal expenses

o 3. Effect of taxes on value Persistence of growth

o Terminal value issue – won’t last forever Key person discount

o (Value of statatus quo – value of firm without person) / value of status quo

READ ILLIQUIDITY DISCOUNT AND REVENUE MULTIPLE DISCOUNT