Why Use Multiples?

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Lezione 17

I multipli di mercato

T. Koller, M. Goedhart, D. Wessels, Valuation, 2010, Chapter 14

(esempi e figure anche da Berk-DeMarzo, Finanza Aziendale 1, cap. 9.4)

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Why Use Multiples?

Multiples can assist in:

1. Testing the plausibility of forecasted cash flows.

2. Identifying disparities between a company’s performance and those of its competitors.

3. Identifying which companies the market

believes are strategically positioned to create more value than other industry players.

Multiples analysis is useful only when performed accurately. Poorly performed multiples analysis can lead to misleading conclusions.

• A careful multiples analysis—comparing a company’s multiples versus those

of comparable companies—can be useful in improving cash flow forecasts

and testing the credibility of DCF-based valuations.

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What Are Multiples?

•

Multiples such as the enterprise-value-to-revenue ratio and the enterprise-value-to- EBITA ratio are used to compare the relative valuations of companies. Multiples normalize market values by revenues, profits, asset values, or nonfinancial statistics.

Specialty Retail: Trading Multiples, December 2009

$ million Debt and Gross Net

Market debt enterprise enterprise

Ticker Company capitalization equivalents value value Revenue EBITDA EBITA

AZO AutoZone 7,915 2,783 10,698 10,535 1.5 7.5 8.5

BBBY Bed Bath & Beyond 10,368 − 10,368 9,477 1.3 9.5 11.3

BBY Best Buy 16,953 2,476 19,429 18,525 0.4 6.0 7.4

HD Home Depot 49,601 11,434 61,035 60,510 0.9 9.2 13.0

LOW Lowe's 34,814 6,060 40,874 39,960 0.8 8.3 12.2

PETM Petsmart 3,386 634 4,019 3,867 0.7 6.5 10.4

SHW Sherwin-Williams 7,029 1,099 8,128 8,044 1.1 9.5 11.4

SPLS Staples 18,054 3,518 21,572 20,938 0.9 10.1 13.2

Mean 1.0 8.3 10.9

Median 0.9 8.8 11.4

Deviation (percent) ¹ 38.1% 17.3% 18.2%

1 Deviation = Standard deviation/median.

1-year forward multiples (times)

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Session Overview

• During this session, we will use three guidelines to build a careful multiples analysis:

1. Use the right multiple. For most analyses, enterprise value to EBITA is the best multiple for comparing valuations across companies. Although the price-to- earnings (P/E) ratio is widely used, it is distorted by capital structure and

nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value) and denominator (earnings) on the same underlying assets. For instance, if you exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.

Refine the sample to peers that have similar outlooks for long-term growth and return on invested capital (ROIC).

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Enterprise Value to EBITA

(1 T) 1 g

Value ROIC

EBITA WACC g

 

−  − 

 

= −

g g

−



 

 −

= WACC

1 ROIC NOPLAT

Value

EBITA(1-T) 1 g Value ROIC

WACC g

 − 

 

 

= −

Substitute EBITA(1 − T) for NOPLAT.

Start with the key value driver formula.

Divide both sides by EBITA to develop the enterprise value multiple.

When computing and comparing industry multiples, always start with

enterprise value to EBITA. It tells more about a company’s value than

any other multiple. To see why, consider the key value driver formula

developed earlier:

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Enterprise Value to EBITA

g T g

−

 

 

  −

−

= WACC

1 ROIC )

(1 EBIT

Value

• Let’s use the formula to predict the enterprise-value-to-EBITA multiple for a company with the following financial characteristics:

• Consider a company growing at 5 percent per year and generating a 15

percent return on invested capital. If the company has an operating tax rate at 30 percent and a 9 percent cost of capital, what multiple of EBITA should it trade at?

7 .

% 11 5

% 9

15%

1 5%

) 30 . (1 EBIT

Value =

−

 

 

  −

−

=

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Distribution of EV to EBITA

• The majority of companies fall between 7 times and 11 times

EBITA. If the company or industry you are examining falls outside this range, make sure to identify the reason.

Number of observations

1 Excluding financial institutions, real estate companies, and companies with extremely small or negative EBITA.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Enterprise value to EBITA

S&P 500¹: Distribution of Enterprise Value to EBITA, December 2009

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Why EV to EBITA and Not Price to Earnings?

• A cross-company multiples analysis should highlight differences in performance, such as differences in ROIC and growth, not differences in capital structure and/or

nonoperating items effect.

• Although no multiple is completely independent of capital structure, an enterprise value multiple is less susceptible to distortions caused by the company’s debt-to-equity

choice. The multiple is calculated as follows:

EBITA

Equity MV

Debt MV

EBITA

Value

Enterprise +

=

• Consider a company that swaps debt for equity (i.e., raises debt to repurchase equity).

• EBITA is computed pre-interest, so it remains unchanged as debt is swapped for equity.

• Swapping debt for equity will keep the numerator unchanged as well. Note, however, that EV may change due to the second-order effects of signaling, increased tax shields, or higher distress costs.

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Why EV to EBITA and Not Price to Earnings?

• To show how capital structure distorts the P/E, consider four companies, named A through D. Companies A and B trade at 10 times enterprise value to EBITA, and Companies C and D trade at 25 times enterprise value to EBITA.

P/E Multiple Distorted by Capital Structure

Since Companies A and B trade at low enterprise value multiples, the price-to-earnings ratio drops for the company with higher leverage (because EV/EBITA is lower than D/IE)

Since Companies C and D trade at high

enterprise value

multiples, the price-to- earnings ratio increases for the company with higher leverage

(because EV/EBITA is higher than D/IE)

$ million

Income statement Company A Company B Company C Company D

EBITA 100 100 100 100

Interest expense − (20) − (25)

Earnings before taxes 100 80 100 75

Taxes (40) (32) (40) (30)

Net income 60 48 60 45

Market values

Debt − 400 − 500

Equity 1,000 600 2,500 2,000

Enterprise value (EV) 1,000 1,000 2,500 2,500

Multiples (times)

EV to EBITA 10.0 10.0 25.0 25.0

Price to earnings 16.7 12.5 41.7 44.4

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Why EBITA and Not EBIT?

• Consider three companies, named A, B, and C. Each company generates the same level of underlying

operating profitability; they differ only in size.

• Since all three companies generate the same level of operating

performance, they trade at identical multiples before the acquisition of B by A.

• Following the acquisition, however, amortization expense causes EBIT to drop for the combined company and the enterprise value-to-EBIT multiple to rise.

Enterprise-Value-to-EBIT Multiple Distorted by Acquisition Accounting

$ million

EBIT Company A Company B Company C Company A+B Company C

Revenues 375 125 500 500 500

Cost of sales (150) (50) (200) (200) (200)

Depreciation (75) (25) (100) (100) (100)

Amortization − − − (25) −

EBIT 150 50 200 175 200

Invested capital

Organic capital 750 250 1,000 1,000 1,000

Acquired intangibles − − − 125 −

Invested capital 750 250 1,000 1,125 1,000

Enterprise value 1,125 375 1,500 1,500 1,500

Multiples (times)

EV to EBITA 5.0 5.0 5.0 5.0 5.0

EV to EBIT 7.5 7.5 7.5 8.6 7.5

After A acquires B Before acquisition

* If amortization is recorded because of capitalized investments (e.g. software) subtract the “operating” amortization from EBITDA to compute EBITA

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Why EBITA and Not EBITDA?

• Many financial analysts use multiples of EBITDA, rather than EBITA, because depreciation is a noncash expense, reflecting sunk costs, not future investment.

• But EBITDA multiples have their own drawbacks. To see this, consider two companies, which differ only in outsourcing policies. Because they produce identical products at the same costs, their valuations are identical ($3,000).

• What is each companies EV-to-EBITDA multiple and why are they different?

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Why EBITA and Not EBITDA?

When depreciation is not an accurate predictor of future capital expenditures,

EBITDA scales a company better than EBITA !!!

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Use Forward-Looking Multiples

• When building multiples, the denominator should use a forecast of profits, rather than historical profits.

– Unlike backward-looking multiples, forward-looking multiples are consistent with the principles of valuation—in particular, that a company’s value equals the present value of future cash flows, not sunk costs.

– Second, forward-looking earnings are typically normalized,

meaning they better reflect long-term cash flows by avoiding

one-time past charges.

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Use Forward-Looking Multiples

• To build a forward-looking multiple, choose a forecast year for EBITA that best represents the long-term prospects of the business.

• In periods of stable growth and profitability, next year’s estimate will suffice. For companies generating extraordinary earnings (either too high or too low) or for companies whose performance is expected to change, use projections further out.

Pharmaceuticals: Backward- and Forward-Looking Multiples, December 2007

Whereas historical P/E ratios across

pharmaceutical companies show significant variation…

Price/earnings Enterprise value/EBITA

2007 net income Estimated 2008 EBITA¹ Estimated 2012 EBITA¹ 38

27 24 20 20 19 18 16 14 13 12 Merck

Bristol - Myers Squibb Abbott Eli Lilly Novartis Pfizer Johnson & Johnson Sanofi - Aventis GlaxoSmithKline Wyeth AstraZeneca Schering - Plough N/A²

16 17 16 13

17 13

15 13

15 12

15 16

12 12 12 12 13 13 12 12 12 12 12 11

the forward-looking EV-to-EBITA multiples are nearly

identical.

1Consensus analyst forecast.

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Session Overview

• During this session, we will use three guidelines to build a careful multiples analysis:

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Calculate the Multiple in a Consistent Manner

• There is only one approach to building an enterprise-value-to-EBITA multiple that is theoretically consistent. Enterprise value must include all investor capital but only the portion of value attributable to assets that generate EBITA.

• Including value in the numerator without including its corresponding income in the denominator will systematically distort the multiple upward.

• Conversely, failing to recognize a source of investor capital, such as

minority interest, will understate the numerator, biasing the multiple

downward. If the company holds nonoperating assets or has claims on

enterprise value other than debt and equity, these must be accounted for.

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Consistency: Nonoperating Assets

• Company A holds only core operating assets and is financed by traditional debt and equity.

• Company B operates a similar business to Company A, but it also owns $100 million in excess cash and a minority stake in a nonconsolidated subsidiary, valued at $200 million.

• Since excess cash and

nonconsolidated subsidiaries do not contribute to EBITA, they should not be included in the numerator of an EV-to-EBITA multiple.

Enterprise Value Multiples and Complex Ownership Partial income statement

Company A Company B

EBITA 100 100

Interest income − 4

Interest expense (18) (18)

Earnings before taxes 82 86

Gross enterprise value

Value of core operations 900 900

Excess cash − 100

Nonconsolidated subsidiaries − 200

Gross enterprise value 900 1,200

Debt 300 300

Minority interest − −

Market value of equity 600 900

Gross enterprise value 900 1,200

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Consistency: Include All Financial Claims

• For Company C, outside investors hold a minority stake in a consolidated

subsidiary.

• Since the minority stake’s value is

supported by EBITA, it must be included in the enterprise value calculation.

Otherwise, the EV-to-EBITA multiple will be biased downward.

• The numerator should include not just debt and equity, but also minority

interest, the value of unfunded pension liabilities, and the value of employee grants outstanding.

Enterprise Value Multiples and Complex Ownership Partial income statement

Company A Company C

EBITA 100 100

Interest income − −

Interest expense (18) (18)

Earnings before taxes 82 82

Gross enterprise value

Value of core operations 900 900

Excess cash − −

Nonconsolidated subsidiaries − −

Gross enterprise value 900 900

Debt 300 300

Minority interest − 100

Market value of equity 600 500

Gross enterprise value 900 900

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Consistency: Final Calculus

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Advanced Adjustments

For companies with rental expense or pension assets, two additional adjustments can be made.

1. The use of operating leases leads to artificially low enterprise value (missing debt) and EBITA (lease interest is subtracted pre-EBITA). Although operating leases affect both the numerator and denominator in the same direction, each adjustment is of a different magnitude.

Interest Lease

Implied EBITA

Equity Leases)

ng PV(Operati Debt

EBITA Value Enterprise

+

= +

2. To adjust enterprise value for pensions, add the present value of unfunded pension liabilities to debt plus equity. To remove gains and losses related to plan assets, start with EBITA, add back pension expense, and deduct any service costs.

Enterprise Value = Debt + PV(Unfunded Pensions) + Equity EBITA EBITA + Pension Expense - ServiceCost

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Session Overview

• During this session, we will use three guidelines to build a careful multiples analysis:

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Selecting a Robust Peer Group

To create and analyze an appropriate peer group:

• Start by examining other companies in the target’s industry. But how do you define an industry?

• Potential resources include the annual report, the company’s Standard Industry Classification (SIC), or its Global Industry Classification

Standard (GICS).

• Once a preliminary screen is conducted, the real digging begins. You must answer a series of strategic questions.

• Why are the multiples different across the peer group?

• Do certain companies in the group have superior products, better

access to customers, recurring revenues, or economies of scale?

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Expect Variation Even within an Industry

• As demonstrated earlier, the enterprise-value-to-EBITA multiple is driven by growth, ROIC, the operating tax rate, and the company’s cost of capital.

(1 T) 1 g

Value ROIC

EBITA WACC g

 

−   −  

= −

Peers in the same industry will have similar risk profiles

and consequently similar costs of capital.

Since growth will vary across companies, so

will their enterprise value multiples.

Be careful comparing across countries. Different tax rates

will drive differences in multiples.

Companies with higher ROICs will need less capital to grow. This will

drive higher multiples.

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ROIC and Growth Drive Variation

• The companies below fall into three performance buckets that align with different multiples. The companies with the lowest margins and low growth expectations had multiples of 7x. The companies with low growth but high margins had multiples of 9x.

Finally, the companies with high growth and high margins had multiples of 11x to 13x.

Factors for Choosing a Peer Group

Valuation multiples Consensus projected financial performance Enterprise value/ Sales growth, EBITA margin,

EBITA 2010–2013 2010 Performance

(percent) (percent) characteristics

Low growth, low margin Low growth, high margin High growth, high margin

7 7 9 9 11

13 Company A

Company B Company C Company D Company E Company F

5 3

4 3

7 8

12 6

21 24 18

24

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Alternative Multiples: EV/Revenues (EV/S)

• EV/S is useful to companies with volatile earnings or other situations when earnings fail to represent long-term operating potential.

• In other situations it can be used only in a regression mode (typical EV/S versus EBITA o EBITDA margin)

S EBITA EBITA

EV S

EV = ×

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Alternative Multiples: PEG Ratios

• EV/EBITA multiple will differ across companies when projections of ROIC and growth differ. To control for the variation in growth, analysts sometimes report a price-to- earnings-growth (PEG) ratio

• The traditional way to calculate PEG ratios is to divide the P/E by expected growth in earning per share (EPS) multiple by 100.

• A modified version is:

ate ITAGrowthR ExpectedEB

EBITA PEGRatio

_Adj

EV

= × 100

/

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Alternative Multiples: PEG Ratios

• In any case, the PEG ratio controls only for growth, not for ROIC

• There is no standard time frame for measuring expected growth (one-year, two-year, or more)

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Closing Thoughts

A multiples analysis that is careful and well reasoned not only will provide a useful check of your discounted cash flow (DCF) forecasts but also will provide critical insights into what drives value in a given industry. A few closing thoughts about multiples:

1. Similar to DCF, enterprise value multiples are driven by the key value drivers, return on invested capital and growth. A company with good prospects for profitability and growth should trade at a higher multiple than its peers.

2. A well-designed multiples analysis will focus on operations, will use forecasted profits (versus historical profits), and will concentrate on a peer group with similar

prospects.

• P/E ratios are problematic, as they commingle operating, nonoperating, and financing activities, which leads to misused and misapplied multiples.

3. In limited situations, alternative multiples can provide useful insights. Common alternatives include the price-to-sales ratio, the adjusted price-earnings growth (PEG) ratio, and multiples based on nonfinancial (operational) data.

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