Multiples

Four steps to using multiples

1. Definitional tests
o is EPS LTM or last fiscal year, etc.
2. consistency
o Numerator must be same value as denominator equity or enterprise
3. Uniformity
o Make sure fiscal year is same for high growth industries, less problem
in mature
4. Descriptional tests
o Median, distribution, etc.
Determinants
o Every multiple has risk, growth, and cash flow generating potential
o Firms with lower risk, higher growth, and greater cash flow potetntial
should trade higher
Companion variable variable that dominates explanation for changes in
multiple
What is a comparable firm
o One with cash flow characteristics, growth potential, and risk similar
to analyzed company
DCF assume markets make mistakes, that they correct them over time, and
that these mistakes can happen across industries and the market
Relative valuation individual stocks can be mispriced, but market is correct
on the whole

P/E Ratio

Differences in P/E for high growth firms

o 1. Volatility in earnings per share growth
o 2. Management options
Diluted shares can make differences between diluted and
primary EPS diff.
Comparing P/E ratios
o Same industry can have firms with different business mixes, risk, and
growth profiles
o Leads to bias in results if you just apply the average
Regression
o Control explicitly for one or two variables and create a regression
o Use regression equation to predict PE ratios

PEG Ratio

Issues
o Still doesnt consider risk riskier companies will have lower PEGs
and look more undervalued

o
o

Firms with lower returns on equity or lower payout ratios will have
lower PEG and look more undervalued
Growth itself is volatile in determining PEG ratios at the extreme ends

EV/EBITDA

Reasons
o 1. Compare multiples across firms with different financial leverage
o 2. Different depreciation methods cause differences in NI and EBIT
but not EBITDA
o 3. Less negative EBITDA companies
o Good for companies with firms that require large investments in
infrastructure with long gestation periods telecom, toll road, airport,
construction, etc.
Often used in capital intensive firms with heavy infras investments
o Wrong becasuse
o Many of firms tend to have high cap ex to drain cash flow
o Good reasons
Depreciation methods vary greatly
Bulk of investment in infrastructure has been made already

Book Value multiples

1. Stable intuitive measure of value to be compared to MV

2. If accounting standards are same across firm, it can show signs of over or
under valuation
3. Less firms with negative BV
Private Company valuation

Adjusting for nondiversification cost of equity

o Beta measures the risk added by an investment to a diversified
portfolio
Best suited for marginal investors that are diversified
o If owner has all wealth in company exposed to all risk in firm and
market risk
o Total beta = market beta / correlation of stock to index
Cost of debt
o Use interest coverage ratio
o EBIT / interest
Debt ratio
o Use industry average or iterate it based on DCF
Cash flows
o Owner salaries and equity case flows
o 1. Do not consider salaries for owner-managers do not distinguish
between dividends and salaries
o 2. Intermingling of business and personal expenses

o 3. Effect of taxes on value

Persistence of growth
o Terminal value issue wont last forever
Key person discount
o (Value of statatus quo value of firm without person) / value of status
quo

READ ILLIQUIDITY DISCOUNT AND REVENUE MULTIPLE DISCOUNT