Multiples Analysis

 What is Multiples Analysis?

Multiples analysis is considered a relative valuation method that enables you to value assets based on how comparable assets trade in the market. It is derived by dividing the value of assets by valuation drivers (e.g., Revenue, EBITDA, EBIT, Net Income, or EPS).

Profitability is what determines a company's value. Therefore, the value of assets must be consistent with the value driver chosen to compute multiples.

Comparing similar businesses is crucial when employing multiples analysis. For example, supermarkets are likely to have valuation multiples that are very different from those of high-growth industries like technology.

Multiples analysis is normally done by referring to financial ratios as "earnings multiples," such as the price-to-earnings (P/E) ratio. In addition, investors can evaluate a company's value and compare it to its peer group by using a valuation multiple, which is a valuable financial tool.

Although it is the oldest valuation method, multiple analysis is still employed. However, it is currently used in valuation alongside other market-based techniques like discounted cash flow analysis (DCF).

Multiple Components

Since the valuation multiple is fundamentally a ratio, it has two parts; a numerator and a denominator. 

1. The numerator contains a valuation metric of either:
   • Enterprise Value (EV)
   • Equity
2. The denominator contains financial metrics, which could be:
   • Revenue
   • EBITDA 
   • EBIT
   • Net Income
   • EPS

A thorough understanding of the business and its industry is also essential if you want to make a wise choice. For instance, an established industry like construction will have different value multiples than a rapid-growth industry like technology.

Operating KPIs and multiples particular to the industry are also employed on occasion. For example, daily Active Users (DAUs) would be a stronger indicator of a social media company's valuation instead of the company's profits.

Instead of EV/EBITDA, EV/EBITDAR is used as rental costs are added back into the transportation sector. The EV/Revenue multiple is frequently employed when analyzing unprofitable businesses because it is the only viable choice.

For a valuation multiple to be practical, it must have the same numerator and denominator for the represented capital provider (e.g., equity shareholder, debt lender).

When the numerator is an enterprise value, metrics like EBIT, EBITDA, sales, and unlevered free cash flow (FCFF) could all be used as the denominator as they are all unlevered (i.e., pre-debt).

As a result, these indicators are consistent with enterprise value, which is the evaluation of a business independent of the capital structure.

In contrast, measurements like net income levered free cash flow (FCFE) and earning per share (EPS) can be utilized if the numerator is equity value because they are all leveraged (i.e., post-debt) indicators.

Different Types of Valuation Multiples

Financial measurement tools compare one economic statistic to another to improve comparability between various firms. For example, the ratio of one financial indicator, such as share price, to another is known as a multiple (i.e., Earnings per Share). It is a simple method for determining a company's value and comparing it to other companies.

Equity multiples and enterprise value multiples are two different types of valuation multiples. Enterprise value multiples are regarded as superior valuation models to equity multiples since they enable direct comparison of various enterprises, regardless of capital structure. In contrast, equity multiples are artificially affected by the change in the capital structure.

Also, enterprise value multiples tend not to be impacted by changes in accounting policies or standards, unlike equity multiples. The following article explains that enterprise and equity multiples have merits and demerits.

Enterprise Multiples

Enterprise Value multiples and Equity Multiples are the two types of valuation multiples. The Enterprise Value-to-Sales ratio (EV/Sales), EV/EBIT, and EV/EBITDA are examples of Enterprise Value (EV) multiples.

1. EV/Revenue

The EV/Revenue valuation method divides Enterprise Value by annual revenue or sales.

2. EV/EBITDA

It is used to assess the financial health of businesses that operate in the same industry or sector. Enterprise Value is described as a multiple of "Earnings before Interest, Taxes, Depreciation, and Amortization" or "EBITDA."

EBITDA is used in place of the P/E ratio because the cost of debt is not factored into EBITDA.

Using the ratio, one can determine whether the company's value is overvalued or undervalued. Additionally, it aids in investors' comprehension of the firm's risk and financial status.

3. EV/EBIT

The ratio is between EV (Enterprise Value) and the EBIT (Earnings before Interest and Tax). It relies on operating income as the primary driver of valuation and is one of the most commonly used multiples for company comparisons.

4. EV/Invested Capital

EV/Invested Capital is derived by dividing Enterprise Value by Invested Capital. It is most common in sectors with substantial capital investments.

Equity or Market Multiples

Price-to-Earnings (P/E), Price-Earnings-to-Growth (PEG), and Price-to-Sales (P/S) ratios are examples of Equity Multiples, often known as Market Multiples. 

They essentially compare the share price to a fundamental indicator of the company's performance, such as earnings, sales, or book value.

1. P/E Ratio

The price-to-earnings ratio, or P/E ratio, estimates a stock's value by dividing the current share price by the most recently reported earnings per share (EPS). Given that the data is readily available, it is one of the equity multiples that is employed the most frequently.

2. PEG Ratio

The PEG Ratio also referred to as "price/earnings-to-growth," is a valuation indicator that contrasts the expected growth rate of a company with its P/E ratio. In contrast to the more widely used standard P/E ratio, it considers the company's potential future growth.

3. Price/Book Ratio

The price-to-book ratio, often known as the P/B ratio, is a financial measure that compares the stock's current market price with its book value as a percentage of its assets. 

It is frequently employed when assets are used to generate income.

4. Dividend Yield

The amount shareholders get from holding firm stock is known as the dividend yield. One may determine the dividend yield by dividing the dividends per share by the stock price.

Simply put, it is the return investors earn for each dollar invested. If a firm pays a $3.50 dividend and its shares are now trading at $35, its dividend yield is 10%.

5. Price/Sales

The price-to-sales ratio evaluates how much a stock is worth of its revenue (sales) per share. Current Share Price/Sales Per Share = Price/Sales. It is used to calculate the value of a company by estimating how much investors are prepared to pay for every dollar of sales.

The value of an operating business is its Enterprise Value. The Enterprise Value or the Enterprise Value multiples are unaffected by the capital structure.

Since EV multiples enable direct comparison across various companies, even though they may have distinct capital structures, Enterprise Value and multiples are sometimes thought to be better valuation models than Equity Multiples.

On the other hand, Equity Multiples might be artificially impacted even if there are no changes to Enterprise Value. However, investors prefer Equity Multiples since they are simpler to compute and the information is easily accessible.

Investors' Approach to Multiple Analysis 

The multiples-based method of valuation aims, among other things, to make it simpler to compare businesses of various sizes and to offer a straightforward formula for determining a company's worth when just a few important components of its income statement are known. 

The multiples methodology is a common and well-established method that requires no comprehensive multi-year forecasting of free cash flows, unlike discounted cash flows (DCF approach), and is very simple to use.

1. Selecting peers to compare 

A company's activities might become too diverse, undermining its standing as a peer. As a result, investors look for pure plays whenever possible to obtain a more accurate sense of how market participants evaluate a specific industry.

2. Expanding peer search geographically 

Given that most businesses are now global, it makes sense for investors to consider foreign stocks when assembling a group of peers.

While occasionally, there have been valuation differences among public markets worldwide, they are gradually diminishing and have the insignificant impact of geography on valuations.

3. Identifying Outliers

Every statistic conceals a narrative, and trend analyses are among the best ways to reveal that narrative. For example, while multiples are calculated at a specific time, the market cap shows how investors anticipate the development of future cash flow and financial statements. 

These projections and opinions about future performance can be studied by looking at analyst consensus estimates, and recent historical performance data frequently influence them. 

It makes sense that investors review these projections and their peers' most recent performance to spot outliers and decipher the meaning of any specific company's multiples.

4. Applying Premium

The effect of business size on valuation multiples and the necessity to account for liquidity and marketability (or lack thereof) in valuations have been the subject of much academic and financial research. 

Therefore, investors applying a discount or Premium to the multiples of a peer group or previous transactions whose size or liquidity varies from the firm that investors are valuing is customary and advised.

5. Using Median values

Even after removing outliers, most peer groups still show some variation. As a result, even businesses that otherwise like your valuation object may have some ratios that are noticeably out of whack with their peers and, in some circumstances, are orders of magnitude higher or lower.

Therefore, the best practice for investors would be to use the peer group median values instead of the arithmetic mean. Although some data suppliers offer multiples by quartiles for illustration, the median is generally regarded as the best measure to base calculations on.

Investors utilize multiples to identify undervalued or overvalued companies compared to their intrinsic value.

Backward and Forward-looking Multiples

A valuation method known as the "backward-looking multiplier" depicts a company's value based on its historical performance. They are the multiples that result from dividing the present value of a company by its historical profits, revenues, or book value.

A company's future earnings and stock performance are then predicted using this value to a certain extent. 

Although they are helpful, backward-looking multiples merely offer a glimpse into the past and are only sometimes successful when applied to all companies.

Forward multiples are calculated using a company's EBITDA or EBIT for the following twelve months and are referred to as "growth multiples."

Forward-looking multiples are multiples that base their valuation on expected future earnings. They are comparable to the more widely used price-to-earnings ratio in practice. 

However, they utilize a forecasted multiple of a firm's earnings to determine value rather than price as a basis.

It is frequently used to calculate the valuation of fast-growing businesses with profit projections that outperform those of the previous year. Forward-looking multiples, instead of backward-looking multiples, are consistent with valuation concepts. 

In particular, a company's worth is determined by its current cash flow rather than its historical profits.

Steps in Performing Multiples Analysis

Similar to the Discounted Cash Flow approach, the main challenge of Valuation Multiples is to predict the evolution of the various financial statement elements to provide future firm valuations. 

We can consider the valuations of some comparable assets and determine the ratio or multiple that is more acceptable when calculating a company's multiple. 

The median of the firms' ratios or certain high or low percentiles can be used to create a range in which the target company could be. Then, by aggregating these ratios, we can obtain a potential Multiple for the target company we want to value.

Step 1: Equity Value Calculation

Let's assume we have the financial data for three companies, i.e., Share Price and Fully Diluted Shares. Market Cap or Equity Value can be calculated by multiplying the share price with the Fully Diluted Shares Outstanding. Market Cap or Equity Value is used as a numerator for Multiples valuation.

Step 2: Enterprise Value Calculation

You can calculate EV using the following formula: 

Market Cap + Preferred Stock + Minority Controlling Interest + Debt – Cash 

Assuming no preferred stock and minority interest. We can calculate EV as below:

The information can be sourced from a company's 10-K if the company you are researching is a public company or may be sourced from Bloomberg or Capital IQ.

Step 3: Valuation Multiples Calculation

After calculating the numerator (Equity and Enterprise Value), we need the denominator, or financial metrics, to compute Valuation multiples.

In Millions ($), LTM

Now that we have all the financial data we need, we can compute Multiples for New York Ltd, London Ltd, and Melbourne Ltd.

Calculating Stable Multiples for Valuation

Applying multiples can be aided by four fundamental principles:

• Using peers with comparable ROIC and growth predictions.

• Using forward-looking multiples.

• Using enterprise-value multiples and adjusting enterprise-value multiples for non-operating elements.

1. Employ peers with comparable growth and ROIC prospects

Finding the ideal organizations for a similar set takes time; the capacity to select suitable comparables separates seasoned professionals from beginners.

Most financial analysts begin by looking at the industry in which a company operates, although enterprises frequently need to be defined.

In its annual report, the corporation may name its rivals. Using the U.S. government's Standard Industrial Classification codes is an alternative.

The Global Industry Classification Standard (GICS), recently created by Morgan Stanley Capital International and Standard & Poor's, is a marginally superior (but proprietary) approach.

The real investigation can start once you have a preliminary list of comparables. But, first, you must investigate each business on the list and provide important clarifications, such as why the multiples vary throughout the peer group.

Do some of the companies in it have better access to clients, better products, regular income, or scale economies?

Companies with a competitive advantage within a given industry will trade at higher multiples if these strategic advantages materialize into superior ROICs and growth rates.

It will help if you become an authority on any company's financial and operational details, including what products they offer and how they make money, expand, and generate income.

Hence, a comps table with a better peer group, which may even be as small as one, would be easier to design if you have a lot of deal experience. 

2. Forward-looking multiples

Multiples based on forecasted rather than historical earnings would be consistent with the valuation principles and the empirical data.

If historical data must be used because no credible forecasts are available, utilize the most current data and exclude one-off items. 

According to empirical data, forward-looking multiples are better value predictors, especially for businesses that have recently completed a significant transaction, such as purchasing another company or introducing a new product. 

The results of this acquisition would not be reflected in their TTM EBITDA, but their prediction for the following year would make the forward multiple applied to that projection more pertinent.

Additionally, if the next 12 months appear promising, corporations coming off a particularly terrible year or downcycle may choose the forward multiple. Finally, it might be best to determine the company's valuation using a forward multiple if it has a full backlog of services or projects. 

3. Using EV (Enterprise Value) Multiples

P/E multiples have two significant problems. First of all, they are initially systematically impacted by the capital structure. Second, P/E ratios increase with leverage for companies whose unlevered P/E (the ratio they would have if wholly financed by equity) is larger than one over the cost of debt. 

So, by exchanging debt for equity, a firm with a relatively high P/E ratio on its total equity balance sheet might feign an increase in its P/E ratio.

Second, earnings, which are the basis for the P/E ratio, include many non-operating factors like write-offs and restructuring charges, so they can be deceiving as they are only one-off items.

The Enterprise Value-to-EBITDA ratio can be used as a substitute for the P/E ratio. This ratio is generally less sensitive to being manipulated by modifications to the capital structure.

A change in capital structure won't have a systematic impact because Enterprise Value includes both debt and equity, and EBITDA is the profit accessible to investors. Therefore, changes will only result in a higher multiple if they reduce the cost of capital.

Adjusting Enterprise Value-to-EBITDA for Non-operating Items

Even enterprise-value-to-EBITDA multiples must be adjusted for non-operating items hidden within Enterprise Value and EBITDA.

Both of these must be adjusted for these non-operating items, such as excess cash and operating leases, even though the one-time non-operating items in net income make EBITDA superior to earnings for calculating multiples.

These non-operating items include excess cash and operating leases. Failure to do so could lead to inaccurate results. (Contrary to popular belief, multiples are not easily calculated; accurate calculation requires time and effort.) Here are the most frequent modifications.

1. Excess cash and other non-operating assets: The Enterprise Value should be free of excess cash because EBITDA does not include interest income from surplus cash. Therefore, non-operating assets must undergo a separate evaluation.

2. Operating Leases: Companies with many operating leases have an artificially low Enterprise Value and an artificially low EBITDA since the value of lease-based debt is ignored.

3. ESOs (Employee Stock Options): The present value of all outstanding employee grants should be added to arrive at the Enterprise Value.

Subtract new employee option awards (as disclosed in the footnotes of the company's annual report) from EBITDA to avoid artificially high EBITDA for businesses that don't expense stock options.

4. Pensions: The present value of pension liabilities should be included in the Enterprise Value. 

Start with EBITDA, add pension interest expense, subtract recognized returns on plan assets, and make any necessary adjustments for any accounting changes to remove the non-operating gains and losses associated with pension plan assets.

Conclusion

The ease of employing multiples in valuation has both benefits and drawbacks. It has the disadvantage of reducing complex information to just one value or a set of values. 

This effectively ignores other elements, such as growth or decline, that impact a company's intrinsic valuation of the business. However, this simplicity enables a financial analyst to perform quick calculations to determine the value of a company.

Comparing businesses or assets can also be challenging when employing numerous analyses. This is due to the possibility of various accounting policies among businesses, even if they appear to have the same company operations. 

As a result, comparisons are less reliable, and multiples are susceptible to being read incorrectly.

Multiple analyses similarly ignore the future because it is static. It does not consider the company's growth in its business operations and only finds its position for a specific time.

It is possible to compensate for this by utilizing specific multiples that consider "leading" ratios.

Researched & Authored by Frank Pereira I LinkedIn

Reviewed and Edited by Justin Prager-Shulga | LinkedIn

Free Resources

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• Capitalization Rate
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