CHAPTER 18

ADDITIONAL ISSUES IN MULTIPLES ANALYSIS

LEARNING OBJECTIVES
1.
2.
3.
4.
5.

How capital structure affects the PE ratio and how to adjust for this difference in a PE valuation.
How to adjust for accounting differences in a PE valuation.
How to perform multiples valuation on a firm with losses or near-zero earnings.
How to use multiples valuation on firms with several lines of business.
How analysts use the market/book ratio to value firms.

TRUE/FALSE QUESTIONS
1.

As a general rule, two otherwise similar firms with different capital structures will have different PE ratios.
(easy, L.O. 1, Section 1, true)

2.

One of the simplest ways for an analyst to deal with differences created by capital structure is to use the
unlevered, pretax PE ratio in a multiples valuation.
(moderate, L.O. 1, Section 1, true)

3.

The denominator of any valuation multiple must be the same measure as the value driver by which it is
multiplied.
(difficult, L.O. 1, Section 1, true)

4.

The unlevered pretax PE is highly sensitive to leverage.

(moderate, L.O. 1, Section 1, false)

5.

When using the unlevered PE ratio, the analyst must be aware that the ratio of the two values, debt plus
equity, divided by EBIT, will vary with leverage.
(moderate, L.O. 1, Section 1, false)

6.

Accounting doesnt matter is a justifiable argument for ignoring reporting differences in multiples
valuation.
(moderate, L.O. 2, Section 1, false)

7.

If two firms are not similar in terms of financial reporting choices, then a PE valuation can be severely
flawed.
(moderate, L.O. 2, Section 1, true)

8.

One way to deal with accounting differences is to adjust the comparable firms reported earnings as if the
firm used the targets reporting choices, or adjust the target to the comparable firms reporting choices.
(moderate, L.O. 2, Section 1, true)

9.

When adjusting earnings for accounting differences, the important concept is to use an earnings number
and a PE that are determined using the same reporting choices for both firms.
(moderate, L.O. 2, Section 1, true)

10.

Some research has shown that current period earnings is a better predictor of future cash flows than is
current period cash flow.
(difficult, L.O. 2, Section 1, true)

11.

Multiples valuation is relatively simple for firms with zero earnings or losses and start-up firms whose
earnings are extremely low.
(moderate, L.O. 3, Section 3, false)

122

12.

When firms operate more than one line of business, each line is likely to have its own PE ratio.
(easy, L.O. 4, Section 4, true)

13.

PE decomposition cannot be used to value firms with marketable securities.

(easy, L.O. 4, Section 4, false)

14.

Valuing a firm using the market/book (MB) ratio is considerably different than using the price/earnings
(PE) ratio.
(moderate, L.O. 5, Section 5, false)

15.

Accounting differences do not affect the MB ratio the way they do with the PE ratio.
(moderate, L.O. 5, Section 5, false)

MULTIPLE CHOICE QUESTIONS

16.

If a certain variable affects the PE ratio, the analyst will most likely:
a. not use the PE ratio in a multiples valuation
b. match on it with comparable firms in a multiples valuation
c. adjust for its effect in a multiples valuation
d. Answers b and c are both correct.
(moderate, L.O. 1, Section 1, d)

17.

The analyst can compare multiples of firms with different capital structures, eliminating the need to match
on this variable, because:
a. the unlevered pretax PE ratio is insensitive to leverage
b. the equity PE ratio varies with leverage
c. the unlevered pretax PE ratio is sensitive to leverage, which can be corrected through adjustment
d. None of the above answers are correct.
(moderate, L.O. 1, Section 1, a)

18.

Mathematically the value of PE equity is the:

a. firms equity minus earnings before interest and taxes
b. pretax debt PE multiplied by interest
c. pretax equity PE ratio multiplied by earnings after interest but before taxes
d. pretax equity PE ratio multiplied by earnings after interest and taxes
(difficult, L.O. 1, Section 1, c)

19.

Regarding PE analysis, mathematically the value of debt is the:

a. pretax debt PE multiplied by earnings before interest and taxes
b. pretax debt PE multiplied by interest
c. pretax debt PE multiplied by earnings after interest but before taxes
d. None of the above answers are correct.
(difficult, L.O. 1, Section 1, b)

123

20.

Regarding adjustments for capital structure differences in a PE valuation, to get the value of the target
firms equity, the analyst will:
a. estimate the unlevered value of the target firm, subtract the value of its debt, and then add the value
created by its leverage
b. estimate the unlevered value of the target firm, add the value created by its leverage, and then subtract
the value of its debt
c. multiply the comparable firms unlevered pretax PE by the target firms EBIT
d. estimate the total value of the target firms debt and equity, less the value it creates by leverage
(moderate, L.O. 1, Section 1, a)

21.

Which of the financial reporting differences below will produce different PE ratios?
a. using straight-line rather than accelerated depreciation
b. the amounts of allowances for uncollectible accounts
c. specific criteria for recognizing revenue
d. All of the above reporting differences will produce different PE ratios.
(moderate, L.O. 2, Section 1, d)

22.

Earnings quality is especially important in multiples valuation because:

a. there are three definitions of earnings quality, which may make a multiples valuation for comparable
firms impossible
b. earnings subject to manipulation are more likely to be understated than overstated, resulting in lower
multiples
c. the firms earnings directly drives the valuation
d. None of the above answers are correct.
(moderate, L.O. 2, Section 1, c)

23.

An analyst determines that a difference in depreciation methods can be adjusted to reduce the error in a
multiples valuation. Although the analyst will probably not have all the necessary accounting information at
hand, the analyst can:
a. still recompute depreciation expense under a different method and plug the amount into an earnings
adjustment for valuation purposes
b. eliminate depreciation expense altogether for both comparable and target firms
c. estimate the amount of depreciation computed under a different method by relating deprecation expense
to the firms gross fixed assets
d. None of the above answers are correct.
(difficult, L.O. 2, Section 1, c)

24.

The price/sales (PS) ratio may be used in a multiples valuation because this approach will eliminate:
a. leverage differences across firms
b. most reporting differences caused by the timing of expense recognition
c. differences in operating margins across firms
d. differences in capital structures across firms
(moderate, L.O. 2, Section 1, b)

25.

The most logical way to eliminate differences and make multiples more comparable is to:
a. use the price/sales (PS) ratio rather than the PE ratio in the multiples valuation
b. use cash flow instead of earnings as the value driver in the valuation
c. not consider accounting differences in the valuation process
d. None of the answers above are correct.
(difficult, L.O. 2, Section 1, d)

124

26.

Which statement below is incorrect regarding PE ratios and firms with near-zero earnings or losses?
a. For firms with losses or near-zero earnings, the PE ratio is virtually meaningless, however the PEG
ratio can be modified to provide useful information for the valuation.
b. A common multiples-based valuation approach for a company with near-zero earnings or losses is to
use some other factor as the value driver.
c. Sometimes start-up companies are incurring losses while experiencing incredibly high growth in
revenues.
d. The PE ratio can be redefined using a forecasting earnings number from a period two or three years in
the future, assuming earnings are expected to reach a normal level by then.
(moderate, L.O. 3, Section 3, a)

27.

A common multiples-based valuation approach for a company with near-zero earnings or losses is to use
some other factor as the value driver. The factor used in determining the ratio of value to some other value
driver is the:
a. number must in some way be earnings related
b. value of the cash flow stream per unit of the value driver
c. expected growth in the number of units of the value driver
d. Answers b and c are both correct.
(moderate, L.O. 3, Section 3, d)

28.

A common multiples-based valuation approach for a company with near-zero earnings or losses is to use
some other factor as the value driver. An example of the factor used in determining the ratio of value to
some other value driver would be:
a. the firms historical earnings from the past
b. the number of hits on the firms Internet site
c. the firms sales during its first year of operations
d. None of the answers above are correct.
(moderate, L.O. 3, Section 3, b)

29.

The process of separating the earnings streams of the different lines of business for a firm and applying
different PEs to each component is called:
a. PE segmentation
b. PE component analysis
c. PE decomposition
d. PE segment separation
(easy, L.O. 4, Section 4, c)

30.

Which of the statements below is incorrect regarding PE decomposition?

a. PEG ratios cannot be used in conjunction with PE decomposition when a firm has several diverse lines
of business.
b. Although the divisions of a firm may be listed in one broad industry classification, if the divisions are
in sufficiently different markets, their multiples are likely to differ, and PE decomposition can be used.
c. Under PE decomposition, using unlevered, pretax PE ratios can eliminate potential leverage
differences.
d. PE decomposition can be used to value firms with marketable securities by adding the value of the
securities in the same way we subtract the value of debt.
(moderate, L.O. 4, Section 4, a)

125

31.

When the target firm has discontinued operations:

a. PE decomposition cannot be used in a multiples valuation
b. the analyst will separate the valuation into two pieces, the value of continuing operations and the value
of discontinued operations
c. the separation of discontinued operations from continuing operations applies only to the period in
which the disposal of the discontinued operation occurs
d. the analyst must estimate the value the discontinued operations based on its sales price, net of taxes and
transaction costs
(moderate, L.O. 4, Section 4, b)

32.

What is the relationship among the market/book (MB), price/earnings (PE), and return on equity (ROE)
ratios?
a. There is no common relationship among these three ratios.
b. ROE is not mathematically related to either the MB or PE ratios.
c. ROE is not mathematically related to either the MB or PE ratios, and therefore the majority of factors
that influence ROE do not affect the MB or PE ratios.
d. The MB ratio is the product of the PE ratio and the ROE.
(moderate, L.O. 5, Section 5, d)

33.

The PE ratio is positively related to earnings growth. Because PE is a component of MB, earnings growth
also affects the MB ratio. The analyst can control for earnings growth when comparing MB ratios:
a. only by finding a comparable firm that matches on growth rates
b. either by finding a comparable firm that matches on growth rates or using the PEG ratio in conjunction
with the MB ratio
c. either by finding a comparable firm that matches on growth rates or using the ROE ratio in conjunction
with the MB ratio
d. The MB ratio cannot be used in a situation where the firm has abnormal earnings growth.
(moderate, L.O. 5, Section 5, a)

34.

The factors that influence ROE also affect the MB ratio, because the MB ratio is directly related to the PE
ratio and ROE. Regarding finding and identifying comparable firms to match on the MB and ROE ratios:
a. it is easier to match on MB because the analyst can adjust the book value of one of the firms to be the
same as the other
b. it is easier to match on MB because the analyst can find the firms book value easier than the firms
equity
c. it is easier to match on ROE because the analyst can look for firms within the same industry that have
the same reported ROE
d. Answers a and b are both correct.
(moderate, L.O. 5, Section 5, c)

35.

Which variable does not affect the MB ratio in a multiples valuation?

a. differences in capital structures
b. sales volume
c. accounting differences
d. earnings growth
(moderate, L.O. 4, Section 4, b)

126

ESSAYS
36.

Explain the issue of earnings quality and financial reporting differences in PE valuations and use of the
market/book ratio.
Suggested solution:
Earnings quality is especially important in multiples valuation because earnings drive the valuation.
Accounting differences impact earnings because the differences affect the denominator of the PE ratio. It is
important for the analyst to consider the firms accounting for this reason.
When earnings quality is a concern due to accounting differences, the analyst can adjust the comparable
firms reported earnings as if the firm used the targets reporting choices, or adjust the target firm to the
comparable firms reporting choices. For example, when there are differences in depreciation methods
(straight-line versus an accelerated method), the analyst can estimate the amount of depreciation expense by
relating depreciation expense to some other variable, such as gross fixed assets. This allows the analyst to
convert the earnings of one of the firms to what it would have been if it used the other firms accounting
method (in this case the same deprecation method).
The important thing an analyst should be mindful of is that the valuation should use an earnings number
and a PE that are determined using the same reporting choices for both firms. This will allow the analyst to
use the comparable firm to value the target firm based on PE ratio analysis, without any serious valuation
error.
(moderate, L.O. 2, Section 2)

37.

Discuss how the PE ratio can be used for firms with near-zero earnings or losses.
Suggested solution:
An analyst cannot use the PE or PEG ratios for firms with losses or near-zero earnings, since the ratio
results are virtually meaningless. The analyst can redefine the PE ratio using a forecasted earnings figure
from some time in the future (two, three, or more years in the future), which assumes the firm will reach a
normal level close to the forecasted amounts. This may not always work, however, when a start-up firm
experiences losses while having high growth in revenues (i.e., Amazon.com).
An alternative in such a situation is to use some other factor as the value driver for a multiples valuation.
The analyst could substitute a factor, such as the number of subscribers to a cable service or the number of
hits a firms Internet site has during a certain period, for the value driver. In this case the value driver
does not have to be an earnings number per se.
When the analyst uses some alternative factor for the multiples valuation, there are two factors in
determining the ratio of value to such a value driver: (1) the value of the cash flow stream per unit of the
value driver; and (2) the expected growth in the number of units of the value driver. The analyst may have
to make adjustments in this situation in a similar fashion to PEG ratio adjustment. An analyst, by following
the above guidelines, can successfully use the alternative factor in multiples valuation for firms with nearzero earnings or losses.
(moderate, L.O. 3, Section 3)

127

38.

Comment on the use of normalized earnings multiples and the MB ratio.

Suggested solution:
The MB ratio, like the PE and ROE ratios, is sensitive to different variables. Once an analyst has control
over differences in the ROE, an MB ratio analysis becomes nothing more than a PE study. This means that
the analyst can use the PE ratio as easily as the MB ratio in certain valuations. This calls into question the
use of the MB ratio in any multiples valuation.
When the PE ratio is used in a multiples analysis, there is an implicit assumption that earnings are at a
normal level. If the firms earnings are unusually high or low, the analyst may want to use a normalized
level of earnings to determine the PE ratio. A normalized earnings level is the level at which earnings would
not reflect any aberration for the year under consideration.
The MB ratio can be used in a way that is similar to normalizing earnings for a PE ratio, because using a
firms book value as the value driver is very much like normalizing the earnings level. This is because by
using book value in the denominator of the ratio, it is assumed that the ROEs will be the same for a target
and comparable firm. In such a situation, it may be easier to use the MB ratio than a PE ratio, because the
analyst would not have to take the additional step of normalizing earnings.
(moderate, L.O. 5, Section 5)

128