Technical Question - Impact on Multiples
Company H is a supermarket chain. Company H recently discovered and took possession of an authentic Leonard DaVinci painting inside the supermarket. How does this affect Company H’s EV/EBITDA multiple? How does this affect Company H’s P/E multiple?
“EV/EBITDA is unchanged. P/E multiple should increase.
Company I is an operator of diamond mines. It recently announced that it discovered a new large trove of diamonds in one of its mines. How does this affect Company I’s EV/EBITDA multiple? How does this affect Company I’s P/E multiple?
“Both EV/EBITDA and P/E multiple should increase”.
Could someone explain these to me? I don't totally follow why EV/EBITDA is unchanged in one but increases in the other. Or for that matter why P/E increases in both...chatGPT hasn't been that helpful sadly. Thanks in advance!
Quick recap on the EV to equity bridge:
EV = Equity + Debt + Preferred Equity + Non-controlling interest - Non-core assets
Some also calls this Core EV as I wrote non-core assets instead of cash and cash eq., the simplified version is typical EV = Equity + Net debt (Debt - cash). The reason we deduct cash is that it is normally a non-operating asset, it doesn’t contribute to EBITDA or EBIT, hence you compare apples to apples when you benchmark EV/EBITDA or EV/EBIT.
Since we are talking about a supermarket (core asset) discovering a painting (non-core asset for a supermarket), it enhances shareholder as they can sell the painting and receive cash, but doesn’t increase the core EV nor EBITDA. Equity goes up according to the expected value of the painting, which is deducted from EV as it is a non-core asset.
In the other example we have a mining company (core asset) discovering diamonds (core assets). Hence Equity increases but since it is core asset we don’t deduct it from EV. It will also increase sales, EBITDA and earnings, hence one could argue that P/E and EV/EBITDA could remain the same if the numerator and denominator increases accordingly. For EV/EBITDA LTM or P/E LTM the answer is that both increases, the NTM / future multiples could develop either way.
Just to clarify, so EV stays the same in the first example? Because equity increases by the value of the painting, but value of the painting is also deducted as a non-core asset?
Correct. Let’s say the market value of equity is 100 and market value of debt also 100, with 0 cash on the balance sheet. EV = 100+100=200.
We assume the value of equity is based on normal course of business, hence finding the painting is extraordinary, for simplicity let’s assume it has a value of 10. What happens to the debt? Nothing in this simple example, we still owe 100. What happens to the equity value? Equity = 100+10=110. The operating value of equity is still 100 but now the shareholders also have a painting worth 10 (which they can sell and transform into cash, either way it is non-operating as long as they are not into the art collection business).
Enterprise value = 110+100-10 =200, i.e. unchanged since we deduct the non-operating asset (in this case the painting). If EBITDA was 10 before the finding of the painting, it is still 10 after the finding and EV/EBITDA equal to 20x before and after.
Let us assume we sell the painting for fair value and receive cash. Equity is still 110 but now comprises 100 in operating assets and 10 in cash. Debt is still 100, while net debt is 100-10=90. EV = 110 + 100 - 10, or EV = 110 + 90 (equity + net debt), since we deduct the non-operating asset (in this case cash).
EV = the value of the engine that produces earnings. EBITDA = those earnings. Burning cash (or discovering troves of cash, or art, or gold), changing financing structure, etc. doesn't change either of those variables. The same events almost by necessity change equity-based ratios and metrics, namely both the "P" (market cap) and "E" (net income") in P/E.
Think about EV from a DCF perspective. EV = operating free cash flows. Finding a painting doesn’t improve your operating cash flows since it’s a non-operating asset. So it won’t increase your EV. You will get extra cash though, which improves your equity value (= EV - debt + cash).
So your EV, EBITDA are unchanged (finding a painting doesn’t flow into your P&L)
Your Market cap will increase though as finding a painting doesn’t flow= getting new cash in the bank.
Thank you for nicely explaining it. I just want to add that operating results (EBITDA / EBIT) are not affected by non-operating items. Technically, net income, on the other hand, increases according to the value of the painting, as a non-recurring gain in value, and therefore leads to an increase in Shareholders' equity (note: disregarding tax). Otherwise the balance sheet would not be in balance as the painting is either an asset or cash on the Asset-side (depending on what you do with it).
Trading multiples, EV/EBITDA, EV/EBIT, P/E, etc., should reflect the relative value of the ongoing, recurring business - otherwise less meaningful when comparing businesses. That is why discovering a non-core asset (painting) does not affect the denominator of the P/E multiple; it is a one-off that "nobody" would pay a multiple (e.g. 10x) for. P/E = (Equity value + post-tax value of painting) / recurring earnings
This sounds a lot like a "gotcha" question from an overeager associate somewhere. If a Company stumbled upon ownership of a painting worth a bunch of money, whether or not it is "core to the business", the TEV/EBITDA multiple that shows up on everyone's comp page and that any reasonable analyst would use for analysis is going to go up.. Same thing that would happen if a Company stumbled upon a bag of "excess cash".
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