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March 03
A Beginner's Guide to Valuation Multiples

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 the form:

(Measure of Capital Investment) / (Measure of Return)

 

The measure of capital investment is usually one of the following:

Price                                          (P)

Enterprise (or Firm) Value           (EV)

Book Value                                (Book)

 

Price

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.

 

Equity Value

EV is the value of the equity and debt that finances the firm:

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

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      (E)

EBITDA                            (Earnings Before Interest Taxes Depreciation & Amortization)

EBIT                                 (Earnings Before Interest & Taxes)

FCF                                  (Free Cash Flow)

 

EBITDA

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

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 equipment.

 

FCF is more complicated, but one of the most important measures.  (More on this later.)   

 

What are all these multiples measuring?

Growth.  This 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:

P/E

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.

Weaknesses:

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 manipulate NI.

 

Revenue Multiples: 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.

Weaknesses:

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 multiples: 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 depreciation/amortization component.  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. 

Weaknesses:

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 cash flows. 

 

Price/Book

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 equity investments. 

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. 

Weaknesses:

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. 

Comments

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Re: A Beginner's Guide to Valuation Multiples

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 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

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 on 8/16/2011 4:42 PM

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Thanks

This was very accurate and thorough, I appreciate it
 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

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 on 8/16/2011 4:42 PM

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Comments

Thanks

This was very accurate and thorough, I appreciate it
 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

Informative Article

great article, look forward to reading more. REmember, <a href="/trading/arbitrage_bookmakers_intro" title="Arbitrage">Sports Arbitrage Betting</a> is very easy and there is loads in US
 on 8/16/2011 4:42 PM

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 on 8/16/2011 4:43 PM

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 on 2/16/2014 10:03 PM

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Comments

Thanks

This was very accurate and thorough, I appreciate it
 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

Informative Article

great article, look forward to reading more. REmember, <a href="/trading/arbitrage_bookmakers_intro" title="Arbitrage">Sports Arbitrage Betting</a> is very easy and there is loads in US
 on 8/16/2011 4:42 PM

Re: A Beginner's Guide to Valuation Multiples

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 on 8/16/2011 4:43 PM

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 on 2/16/2014 10:03 PM

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Comments

Thanks

This was very accurate and thorough, I appreciate it
 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

Informative Article

great article, look forward to reading more. REmember, <a href="/trading/arbitrage_bookmakers_intro" title="Arbitrage">Sports Arbitrage Betting</a> is very easy and there is loads in US
 on 8/16/2011 4:42 PM

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 on 8/16/2011 4:43 PM

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 on 2/16/2014 10:03 PM

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Comments

Thanks

This was very accurate and thorough, I appreciate it
 on 10/8/2009 2:20 AM

Re: A Beginner's Guide to Valuation Multiples

Great article :-)  Mark  http://www.welches-fahrrad.de
 on 8/3/2011 11:34 AM

Informative Article

great article, look forward to reading more. REmember, <a href="/trading/arbitrage_bookmakers_intro" title="Arbitrage">Sports Arbitrage Betting</a> is very easy and there is loads in US
 on 8/16/2011 4:42 PM

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