Comps Multiples Interview Questions

Hey folks, I've been tested with a few questions about multiples and wanted to understand them more fully:

1) There are two operationally identical companies. HighD has a high debt balance. LowD has low debt. Assume the WACC is the same for both. Assume the market values both companies correctly. Which of the following is incorrect:

a) P/E is a preferable multiple to EV/EBIT for comparing these two companies.

b) Both companies will have an identical EV/EBITDA multiple.

c) HighD will likely have a different PE multiple than LowD.

d) Both companies will have an identical enterprise value.

e) Both companies will have identical returns on invested capital.

2) Same setup. Identical companies, but one has more reinvestment. What can we say about the EV, EV/EBITDA, EPS, and P/E?

3) Same setup. Identical companies, but one has longer useful life for its assets. What can we say about the EV, EV/EBITDA, EPS, and P/E?

Hopefully this helps you guys out too!



If it helps, here are my initial thoughts and responses: 

1)  A: True. P/E is basically taking Returns expected to equity / Net income. PV of LFCF to equity will be lower. The equity return expectations will be adjusted downwards for the high debt company. The net income will also be lower for HighD due to the increased depreciation expense on the income statement. You end up taking the differences in the company cap structures into account. EV/EBIT is good in that it considers returns to both debt and equity. However, the EBIT is the same for both HighD and LowD. Effectively, you have your EV adjusting to the difference in cap structure (EV should be higher for HighD because EV = equity + net debt), and you have no adjustment on the EBIT. The numerator and denominator are imbalanced. The EV/EBIT doesn't give you as clean of a comparison as the P/E does for the two companies.

B, C, & D: False, given response to A.

E: False ROIC = NOPAT / Invested capital = EBIT * (1-tax rate) / (book equity + net debt). EBIT is the same for both companies, as is the tax rate. The invested capital portion is larger for HighD. Therefore, I believe I should select E as the incorrect response.

Note: The fact that B, C, & D align with each other probably points to them being correct (aka not our choice). I know I'm making an error because they can't all be false. Long story short, I'm probably incorrect about something here, and I'm not sure what it is.

2) More reinvestment = more CapEx = more depreciation. EV expectations will be lower for companies when they have lower returns to their capital. EBITDA will be unchanged, as it adds back the D&A expense. EV/EBITDA will be lower. Equity holders should have lower expectations for capital return, so I expect Price/share to drop. EPS = NI / Shares. NI will be lowered by the depreciation amount. Price/share and EPS both drop, so P/E has an unclear effect depending on the magnitude of the depreciation influence.

I'm not sure about the P/E movement conclusion – Price/share might drop more because you factor in all the $ lost to CapEx vs just the depreciation, pointing to a lower P/E.

3) Longer useful life = less depreciation today. Looking at DCF value, the PV of FCF is going to be lower because you aren't maximizing $ inflow at present. $ inflow is delayed because you don't have the depreciation tax shield up front – it's spread out. Therefore, the value of the business on both and equity and EV value measures will drop. EBITDA is constant because you add back D&A expense. EV/EBITDA is lower for the longer useful life company. EPS is higher for the longer useful life company because you don't have the depreciation expense reducing your net income. P/E sees a lower Price/share and a higher EPS, so the P/E distinctly decreases.

If there's anything that's typically assumed to be held constant in these situations that I'm missing, please let me know because that might be behind some incorrect reasoning.

Hope that made sense – please correct anything you see wrong

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