I was wondering why it is BETTER for a company's multiple such as EV/EBITDA to become lower as time goes on? How does this show good value per say?

Isn't this a skewed thing to say because a company can also grow its enterprise value at the same time as growing EBITDA too no? What if they buy a non-controlling stake in something? Any thoughts would help.

Wut

It's not necessarily traded on discount, you are on the money about that. Whether a stock is trading at discount or not depends on the spread of perceived intrinsic value (not intrinsic value cuz it's not existing) and market price. P/E ratio or any other ratio/ valuation would not be meaningful when considered solely.
Declining business will only be part of the answers, higher risk will also leads to a lower than average P/E. Higher risk means more uncertainty, not foreseeable decline of the business To simplify this question, think about P/E=1/(r-g) when the growth rate is consistent. When risks go up, r will go up.
Hope it helps

The logic behind a valuation based solely upon multiplying a firm's EBITDA by their estimated EV/EBITDA ratio is that it shows what a firm might be worth relative to the market. If other firms in the same industry have been selling at 10x EBITDA, then an approximate relative valuation could be made just by multiplying the firm's EBITDA by 10. If firms like yours have been selling for 10x their EBITDA, the logic is that yours could sell at around this same multiple. This is not a measure of intrinsic value (like a DCF would be), it simply shows what a firm may sell for given the current market conditions of the firm's industry.

multiples are just quick and dirty DCFs. It's hard to do some math on a forum but bear with me.

According to the DCF framework, a stock's price should be the sum of all future earnings discounted to the present. That is:

P = E + E/(1+r) + E/(1+r)^2

you can simplify the right side by factoring the E out

P = E* [ 1 + 1/(1+r) + 1/(1+r)^2 ]

This look like a valuation multiple equation (P = E * something ). The summation term will converge into what we call the P/E ratio (divide by E on both sides)

P/E = 1 + 1/(1+r) + 1/(1+r)^2 ....

obviously I made some unrealistic assumptions like constant earnings but you'll get the same result when you consider the extra details...

..

couchy:

multiples are just quick and dirty DCFs. It's hard to do some math on a forum but bear with me.

According to the DCF framework, a stock's price should be the sum of all future earnings discounted to the present. That is:

P = E + E/(1+r) + E/(1+r)^2

you can simplify the right side by factoring the E out

P = E* [ 1 + 1/(1+r) + 1/(1+r)^2 ]

This look like a valuation multiple equation (P = E * something ). The summation term will converge into what we call the P/E ratio (divide by E on both sides)

P/E = 1 + 1/(1+r) + 1/(1+r)^2 ....

obviously I made some unrealistic assumptions like constant earnings but you'll get the same result when you consider the extra details...

This is what I was looking for, thank you!

Another way to think of it that P/E ratios are the price to buy the earnings of a company. When you buy shares of a company, you are buying a claim on future earnings stream

so a high P/E ratio means it is expensive to buy the ownership over the future earnings. This is possibly because the earnings are stable, or they are expected to grow. Vice versa for cheap P/E ratios.

If that's still confusing - imagine you are at the grocery store buying oranges. There are 2 crates:

Crate 1:
\$10 for 10 oranges or \$1.00 / orange

Crate 2:
\$6 for 5 oranges or \$1.20 / orange

obviously crate 2 oranges are more expensive. We could then assume that crate 2 oranges are more valuable and of better quality based on the fact it is more expensive. The converse should be true as well - higher quality oranges will be sold on the market at higher price per unit.

So a P/E ratio is just the price of buying the future claim on earnings

(you can argue that crate 1 has a bulk discount but for this analogy, crates and oranges are representing stocks and earnings, you wouldn't be able to get a discount as an investor unless you were buying someone's block trade)

Dude, it's a mathematical fucking identity. Value/EBITDA * EBITDA = Value...

mrb87:

Dude, it's a mathematical fucking identity. Value/EBITDA * EBITDA = Value...

I have to hope that this wasn't his question...

mrb87:

Dude, it's a mathematical fucking identity. Value/EBITDA * EBITDA = Value...

This is actually misleading because I could claim EV / Earnings * Earnings = EV is an identity too. But we know this isn't valid as a multiple.

The confusion was that there is a circularity as discussed above that I wasn't sure how to get out of. Damodaran's stuff helps to explain how it gets out of this circularity in regards to EMM. I guess it is just mixing and matching relative and intrinsic valuation approaches that lets us do it and that apparently makes it messy. At least this makes marginally more sense now.

My point was the phrasing of his question sucked.

Also, a mathematical identity is completely independent of the soundness of its components.

Best Response
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That's like asking why do people drive cars without power windows... because it is more accessible/cheaper/easier.

^Agreed. P/E is simple and intuitive. How much earnings am I going to get and how much am I paying for those earnings. Despite the obvious accounting issues, there is evidence that low P/E ratio stocks have outperformed comparable high P/E stocks in the long run. It is still a useful tool for a quick and dirty comparison of two companies.

As for financial institutions, your valuation should be B/S driven. Basically- figure out how much their financial assets are actually worth.

Agree with above. I love the PE ratios and EV/FCF ratios...No ratio is perfect, which is why you should look at a few of them, and certain ratios will matter more in certain industries.

For a bank, P/B is the most useful measure...

You haven't provided enough information to sufficiently answer the question. The key assumption you have to make is that from an operations standpoint, the two companies are the same (gross profit, tax rates, etc.). The second thing you're missing is the market price of the equity, as opposed to the book value.

Given the above, it depends on the type of company you're looking at and what the market considers the optimal leverage structure for that particular company. In general, a moderately levered company will have a lower P/E ratio than one without any leverage. Leverage in the right amounts is good and boosts earnings. That said, if you put too much leverage on a company such that it risks bankruptcy, than the P/E ratio will actually go much higher than that of no leverage at all.

Here is a handy example from Wikipedia comparing no leverage, moderate leverage, and high leverage and the effect on P/E ratios: http://upload.wikimedia.org/wikipedia/commons/5/5c/Effect_of_leverage_on_PER.png

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sorry both companies are the exact same

South Sea Tulip is right.

Furthermore you only posted the financial structure of the companies with no further information, which basically means nothing. As SST points out, you need the market price and the earnings that generates the equity in order to calculate the ratio.

If this was real then they maybe tried to ask a tricky question to see whether you'd think few secs about it or directly give them the right answer ( that it is impossible to tell the ratio with that data).

you can try the damodaran website (google it)...and there are a couple of other wall street training websites that just slipped my mind at the moment.

investopedia? it's a bit thin but has good definitions on most things. if i remember correctly they had various 'tutorials' that took you through different things.

Thanks. I am trying to look for ways on how to do proper multiples on mining companies, however, I have not come across any resources which address the matter.

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