Relative Valuation: Multiples

Created by David Moore, PhD

Key Concepts

1. Relative Valuation Intuition
2. Trading Comps Steps
• Selecting Comps
• Common Multiples
• Last-Twelve Months vs Forward
• Application
3. Transaction Comps
4. Excess Cash

Relative Valuation

• Most asset valuations are relative
• Most equity valuations on Wall Street are relative valuations (approx. 85% of equity research)
• DCF valuations are often influenced by multiples
• Terminal value is often calculated using multiples
• Relative valuation is pricing not valuation.

Why Relative?

• More likely to reflect market perceptions and moods
• Will always lead to significant number of securities that are undervalued or overvalued
• Tailors to portfolio managers (evaluation is relative)
• Require much less information

What is a multiple?

• Numerator: MV of Equity or Enterprise Value
• Denominator
• Revenues or Drivers
• Earnings
• Cash flow
• Book Value

Three Multiple Checks

1. Define the multiple
2. Describe the multiple
3. Apply the multiple

Define the Multiple

• Value and standardizing variable must be to same claimholder
• Multiple must be uniformly estimated for comparable assets

Example:Price to earnings

• Price: Current or average?
• EPS: Most recent, trailing 12 month, forecast

Describe the Multiple

• Average and standard deviation
• Median: can be more reliable depending on sample size and outliers
• How to deal with outliers?
• Throw out? Does this bias estimate?
• Multiples have skewed distributions

Apply the multiple

• What is a comparable firm?
• Same risk, growth, and cash flow characteristics
• Sampling trade-off:
1. Small sample that are "just like you"
2. Large sample that are "mostly kinda like you"
• Conclude stock is under or over valued relative to comparable group.

Market Assumption

Relative Valuation Steps

1. Select comparable companies
2. Pick which multiples you will use
3. Pick timeframe (LTM vs forward)
4. Select distributional statistics
5. Apply statistic to corresponding metric to arrive at a value

Selecting comparables

• Ideally want to match on value drivers
• Almost always will be comparing apples to oranges
• Sources:
• Equity research
• 10-K
• SIC code screens
• Mergent (other financial website)
• Given list of possible comps, narrow based on nature of business and growth prospects (value drivers)

Common Multiples

• Equity Multiples
1. P/E ratio
2. PEG ratio
3. Price to book Ratio
• Enterprise Multiples
1. EV/EBIT
2. EV/EBITDA
3. EV/Revenue

P/E Ratio

• Issues:
• Requires similar capital structure
• Relies on accounting profits
• Value drivers:
• PE=f(Payout Ratio, g, cost of equity)

PEG Ratio

• Issues:
• Does not actually solve for g issue
• Relationship is non-linear
• Value drivers:
• PEG=f(Payout Ratio, g, cost of equity)

Price to book Ratio

• Issues:
• BV can be negative
• Still a historical cost
• Value drivers:
• Price to Book=f(ROE, g, cost of equity, payout ratio)

EV/EBIT

• Removes leverage
• Value drivers:
• EV/EBIT=f(rate of reinvestment, g, WACC, t)

EV/EBITDA

• Removes leverage
• Useful if D&A is large
• Value drivers:
• EV/EBITDA=f(rate of reinvestment, g, WACC, t, DA)

EV/Sales

• Assumes comparable cost structure
• Useful for negative earnings companies
• Value drivers:
• EV/Sales=f(after-tax operating margin,rate of reinvestment, g, WACC)

Other multiples

• EV/monthly subscribers
• EV/website hits

Period of Measurement

• Need to measure denominator
• Two common periods:
1. Last (trailing) twelve months
2. Forward looking (estimate next year)

Last Twelve Months (LTM)

LTM Practice

Select Statistic

• Most common is to use average
• Why might average be misleading?
• Median reduces impact of outliers
• Important to view/analyze the distribution

Example 1: Apply the Multiple

Go Nuts trades at $30 a share and has 30 million shares outstanding. They had revenue of $1 billion, EBITDA of $200 million, Net income of $75 million and Net Debt of $200 million What is Go Nuts implied share price under each multiple? Are they overvalued/undervalued? What are the ratios for Go Nuts?

Example 1: Solution

Transaction Comps

• Transaction Value/ Target EBITDA
• TV/ Target Revenue
• TV/ Target EBIT
• Offer Price per share/ Target EPS
• Offer value/Target NI

Transaction Comps Example

Your company has revenue of $20B, EBITDA of $6.5B, Net income of $5B, and net debt of $1B. There are currently 1B shares outstanding and the current stock price is $50. Given the information below what is the implied share price under each transaction comparable?

Solution

Excess Cash

• Use peer average Cash as a % of Total Assets as proxy for expected cash
• Excess cash is then the Max of Cash-Expected Cash and zero

Excess Cash Example

Gentex Example

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