By Travis O'Neill
If you’ve read any of the articles I’ve written, or watched
CNBC or the read the WSJ, you may be wondering what all these multiples being
thrown around are. These numbers are
valuation multiples, and they represent precisely what their name suggests.
Many different multiples are used and each has its own uses and
drawbacks. The general purpose of
valuation multiples is to see how expensive one stock, industry, or market is
compared to another. As we are
analyzing investments, we would expect these metrics to reflect a return on an
investment, and they do. But since
we generally like to have our multiples be bigger than one, the usual order is
flipped. Valuation multiples take
(Measure of Capital Investment) / (Measure of Return)
The measure of capital investment is usually one of the
Enterprise (or Firm) Value (EV)
Price is simply the value of the firm’s equity, also known
as the Market Capitalization. It is
the amount of money it would take to buy the firm.
EV is the value of the equity and debt that finances the
EV = Market Cap + Long Term Debt – Cash
This measure reflects the total amount of capital invested
in the business in order to produce returns.
(Cash is considered to be free to pay down debt, and is thus subtracted.
You may see the term Net Debt, which equals Debt – Cash).
Book Value is simply the balance sheet value of Total
Assets – Total Liabilities. This
measure reflects the value of the firm at a moment in time if the business
ceased operations and all assets were used to pay down liabilities.
This is the same as the shareholders’
equity (as per the fundamental rule of accounting A=L+E).
The measure of return can vary widely but there are a few
that you will see most often:
Sales or Revenue
(S or Rev)
Net Income or Earnings
(Earnings Before Interest Taxes Depreciation & Amortization)
(Earnings Before Interest & Taxes)
(Free Cash Flow)
EBITDA is commonly used as a measure of cash flow available
to the firm. Depreciation is added
back, as it is a non-cash charge that is taken out of income on the financial
statements. Interest is removed as
we are measuring cash to the firm, some of which can be used to pay interest to
creditors. Taxes are removed because
creditors are paid before any taxes are charged.
EBIT is basically the same as EBITDA, but it excludes
depreciation/amortization as it recognizes that while this is a non-cash charge,
it reflects real expenses that will need to be paid in the future to replace
FCF is more complicated, but one of the most important
measures. (More on this later.)
What are all these multiples measuring?
derives from the simple idea of the value of a perpetuity, which is calculated
as P/R where P is the payment and R is the Required Rate of Return (RROR—the
rate an investor could expect to earn on an investment in another instrument
with the same level of risk). For
example, a firm with a RROR of 10% paying $1 to shareholders with no expected
growth would be worth $1/10% = $10,
or a multiple of 10x ($10/$1, remember multiples are calculated “upside down.”).
So why could a company returning $1 be trading at 20x, or 5x?
Firms’ operations are not steady as a perpetuities are; the former case
reflects a company that is expected to grow and return more than $1 a year, and
the latter reflects a firm expected to do poorly and return less.
In short, a multiple reflects the
market’s expectations for future growth, the growth rate “implied” in the price.
Now for some multiples:
Price to earnings is the most common multiple that you will
see. It is the most intuitive
multiple since it measures how much you, as a shareholder, must pay for $1 of
net income. You will see Trailing
P/E and Forward P/E. The former uses
the earnings over the Trailing Twelve Month (TTM) period, and the latter uses
the estimate for next year’s earnings.
Always be sure to compare like to like, and be very wary of estimates.
Uses and Strengths:
Firstly, it gets right to the point of multiples—how much
profit you are getting from an investment in this company.
It is also easy to calculate and can be used to compare firms with
similar capital structures across industries.
PE is excellent for firms without debt and works well for financial firms
where it is hard to determine the capital structure.&
It is not useful for early stage firms or firms that have
lost money recently. It can be
distorted by capital structure (leveraged firms will tend to have higher P/E
multiples). Net Income is an
accounting construct, which may pose issues.
Yes, in the long run accounting profits will equal cash flow (ignoring
tax deferrals and such). But we know
from Time Value of Money that the timing of these flows is extremely important.
Another issue is that firms can use accounting methods to legally
P/S and EV/Rev
The Price to Sales ratio values a firm based on the revenue
it generates, and I think that it is a very poor metric.
It’s fundamentally a mismatch.
It takes a value that applies to the whole firm (Revenue) to a measure of
only equity (Price). Take the
example of 2 firms that have revenues of $100.
Firm A is financed 50% by debt and firm B is all equity, but they are
otherwise identical. For firm A, P/S
= $100/$50 = 2.0x. For firm B, P/S =
$100/$100 = 1.0x. These firms are
identical including growth prospects, but command different multiples.
This is definitely a problem if used in valuation.
Using EV/Rev instead can solve this problem.
A and B both have EV’s of $100 and EV/Rev of 1.0x.
The only time I would consider using P/S is on financials where EV is
near impossible to calculate.
Unfortunately, P/S is the more commonly used revenue multiple.
EV/Rev is a much better metric, as it matches the return to the proper
investment. Revenue is generated by
all the capital invested in a firm, not just equity.
Uses and Strengths:
A company will always have positive revenue, even when
EBITDA, EBIT, and NI are negative. Thus P/S is good for analyzing firms that are
in early growth stages and/or distressed.
Revenue tends to be the least volatile metric of firm performance, and is
therefore likely to produce steady valuations.
Also, revenue is the only line item on the Income Statement that can be
simply taken at face value (usually), and this makes it useful.
Lastly, this metric is good for comparing firms in the same industry with
different capital structures.
Revenue is not the return that investors really care about.
A firm with a 50% margin will clearly trade at twice the multiple of an
identical firm with 25% margins.
This flaw makes it a very bad way to compare firms between industries, as some
simply have higher margins than others.
EV/EBITDA and EV/EBIT
EV multiples help to lessen the problems of capital
structure differences between firms because they use a measure of return to all
the stakeholders in the business (creditors and equity holders).
The difference between the EBITDA and EBIT metrics is that EBITDA leaves
out the cost of depreciation that is incurred as equipment ages.
While this is not a cash charge, it is a very real cost of doing
business; in fact, some manufacturing firms that are heavily dependant on
expensive machinery account for depreciation as part of cost of goods sold
(COGS). EBITDA is widely used by
lenders because it is a pretty good measure of how much cash is generated by the
firm’s operations, and they can take their payments before any new capital
expenditures are authorized to replace that which is lost by the
This works because lenders have a short time horizon and don’t really care if a
business falls apart after they are paid out.
EBIT takes into account the fact that the capital expenditures that
offset the depreciation/amortization haven’t been taken out of income, so
depreciation/amortization isn’t added back.
Uses and Strengths:
EV multiples are good for comparing firms with varying
capital structures because they place a value on the entire firm, not just the
equity portion. These are the most
widely used valuation multiples by buy-side analysts.
One issue is the quality of earnings (which is subject to
accounting manipulation); revenue recognition is a major issue with EBIT and
EBITDA since all sales are not cash collections.
A firm can have solvency issues while showing a large positive EBITDA.
Lenders watch accounts receivable and other working capital accounts very
carefully for this reason. With
respect to depreciation/amortization, industries that require high fixed asset
balances will have a huge depreciation number, resulting in an overstatement of
Price/Book values the investments in the business at what
they are shown to be on the balance sheet.
Book Value is theoretically the value of assets that were paid for by
Uses and Strengths:
This metric values a business from the standpoint of
exactly what has been invested. It
is good when making a comparison between the valuations of very similar firms.
Book value is nothing but an accounting construct. Assets are supposed to be carried at the
lower of cost or market value, but this is rarely estimated well.
In fact, this issue has been a huge problem for bulge bracket firms that
have large portions of their balance sheets unreadable due to the lack of a
market in complex instruments such as CDOs.
This measure is also highly dependent on industry.
An industry with a low dependence on tangible assets will trade at an
inflated multiple. Also, book value
can be overstated, as evidenced by the fact that some firms trade at less than
1x Book (if this were actually true, investors would buy a controlling stake and
liquidate for the arbitrage profits).
In a real insolvency scenario, the only balance sheet asset that will
generate 100% of book value is Cash (not including the massive lawyer fees).
As you can see, all these multiples have their uses and
problems. When evaluating a
potential investment, you should draw on more than just one multiple to reduce
the inherent problems of each. Is
there a solution to the problems in using all these multiples listed here?
Sort of: using Free Cash Flow (FCF) solves many of the problems with
these standard multiples, though it is far from perfect.
It is the basis for a Discounted Cash Flow analysis, which is a valuation
technique you will learn about extensively if you study finance.
The problem is that you won’t find FCF anywhere on any financial
statement. You have to calculate it yourself, a process that I will write about
in a future article.