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Valuation with multiples: a conceptual analysis

December 2019

Andreas Schueler

Universitaet der Bundeswehr, Muenchen, Germany; andreas.schueler@unibw.de;

https://www.researchgate.net/profile/Andreas_Schueler3

Forthcoming: Journal of Business Valuation and Economic Loss Analysis, 2020

https://doi.org/10.1515/jbvela-2019-0020

ABSTRACT:

Estimating the market price of a company with multiples is common practice. Especially if

several multiples are used simultaneously, the bandwidth of value estimates might be wide.

The paper aims at narrowing down this bandwidth with a conceptual analysis. I analyze the

different ways to average peer multiples, the links between common multiples (‘inter-

multiple’ analysis), the relevance of their components (‘intra-multiple’ analysis) and the

resulting choice between a bottom-up and a top-down approach for deriving a multiple, and

the impact of differing capital structures.

KEYWORDS: valuation, multiples, EV/Sales, EV/EBITDA, EV/EBIT, PE ratio, PB ratio

1
Valuation with multiples: a conceptual analysis

INTRODUCTION

Multiples are used widely in practice for company valuation. Financial analysts, for instance,

apply multiples in addition to discounted cash flow (DCF) valuation to value a company and

derive recommendations for investors. This is confirmed by empirical studies and surveys such

as those by Demirakos, Strong, and Walker (2004), Asquith, Mikhail, and Au (2005), Imam,

Barker, and Clubb (2008), or Mukhlynina and Nyborg (2016). The paper seeks to analyze

characteristics of valuations by multiples to enable analysts to check the consistency of

multiple-based valuations and narrow the range of share price estimates. Thus, the paper

focuses on conceptual issues and not, for instance, on empirical issues such as the forecast

accuracy of different multiples, as investigated by Alford (1992), Cheng and McNamara

(2000), Lie and Lie (2002), Liu, Nissim, and Thomas (2002), Liu, Nissim, and Thomas (2007),

Chullen, Kaltenbrunner, and Schwetzler (2015), and many others.

The starting point of the paper is an alternative to averaging the multiples of the comparable

companies to a peer group multiple. The use of the harmonic mean is advocated based on its

implications regarding invested capital and return. This recommendation is also made, although

in parts with different reasoning, by Baker and Ruback (1999), Beatty, Riffe, and Thompson

(1999), Liu et al. (2002), and Agrrawal, Borgman, Clark, and Strong (2010). Second, several

multiples are available for practitioners. The conceptual links between multiples are of interest

because they allow conclusions to be drawn on the consistency of valuation results, enable the

analyst to detect contradictions, and provide insights into how the valuation results depend

upon the multiple used. They can also help to understand why the empirical explanatory power

and the coefficient of variation differ between multiples as shown e.g. by Chullen et al. (2015).

2
Third, the paper addresses the components of multiples and their reconciliation. It is shown

that the valuation results depend on the decision of the analyst to derive an average multiple

either with a top-down approach or to aggregate it from its components in a bottom-up

approach. Finally, it is shown how multiples, which are not distorted by capital structure, can

be calculated following Holthausen and Zmijewski (2012). The results of the paper could be

useful not only to valuation practitioners but also to researchers because it provides, for

instance, further insights into the reasons why different multiples show variances in power to

explain share prices.

The valuation by multiples is referred to as the market approach. It can be applied by using

prices paid for whole companies, or portions thereof that are considered controlling in nature

in past transactions (completed transaction method, CTM, or transaction multiples) or by using

observable market capitalizations, which is stock price times number of shares outstanding on

a non-controlling basis (guideline public company method, GPCM, or trading multiples). In

the following, I will focus on the latter method.

Estimating share prices by applying the GPCM method (trading multiples) is a well-known

process. In the first step, comparable companies are identified, which should match with

respect to risk, (especially for equity multiples) capital structure, profitability, and solvency.

Although the designation as a peer firm is not necessarily industry dependent, such firms are

often operating in the same industry. In the second step, the multiple is calculated for each peer

firm. Finally, the financial metric (e.g., free cash flow, EBIT, or earnings) of the company to

be valued is multiplied by the average multiple for the derivation of company value. Multiples

are defined as the ratio of company value divided by a financial metric such as sales, EBITDA,

EBIT, or earnings. Multiples can refer to total company value, i.e. the sum of the market value

of equity plus debt from which cash and marketable securities are sometimes subtracted

(enterprise value, EV, or market value of invested capital, MVIC), whereas equity value

3
multiples use the market value of equity as the numerator. Common multiples are EV/Sales,

EV/EBITDA, EV/EBIT, PE ratio, and Price-to-Book (PB) ratio.

The paper aims at narrowing down the bandwidth of possible valuation results and addresses

the steps of the process to estimate share prices as follows: Commonly used multiples are

introduced by using an example, which is evolved throughout the paper. The next section

focuses on the aggregation to a peer group multiple. Then, the links between multiples will be

analyzed. I will show that the results of a valuation based on components of the multiple

(bottom-up) differ from the results derived by the (entire) multiple (top-down). Finally, I show

unlevered multiples can be used as multiples free from distortions caused by capital structure

effects.

EXAMPLE

This paper focuses on the following multiples: EV to sales, EV to EBITDA, EV (or MVIC) to

EBIT, PE ratio, and PB ratio. Company A is to be valued by Guideline Public Company

Method (trading multiples). I assume to have identified three comparable firms, B, C, and D.

Furthermore, I assume that the fiscal year of all companies ended just recently. 1 The value of

debt and equity are as of the end of the fiscal year. The other financial data, such as earnings,

are defined as the consensus expectations for the current year, which has just begun (forward

looking multiples). However, the discussion in the remainder of the paper does not depend

upon whether trailing or forward-looking multiples are being used. I assume non-negative

surpluses and zero growth. Thus, the change (variation) in net working capital, capital

expenditures exceeding depreciation, and sales growth are not considered for simplicity for

1 For simplicity, I assume that the interest-bearing debt equals net debt because no liquid assets exist and no
interest income is considered. Therefore, EV and MVIC are equal to the sum of market value of equity and debt.

4
most of the paper. Table 1 provides the data, including a few standard financial ratios like

margins and rate of returns.

INSERT TABLE 1 HERE

To account for different tax regimes, differing corporate tax rates are employed, as are interest

rates differing between companies. Based on data from the peer companies, multiples can be

calculated using the results as provided in Table 2. For the EV multiples, debt employed of

company A (USD 3 million) must be deducted to move from entity value to the market value

of equity.

INSERT TABLE 2 HERE

Although it may appear captious, it might seem implausible to classify a company as

comparable if the range of multiples varies considerably. Nevertheless, this is the case for the

example, as Figure 1 shows.

INSERT FIGURE 1 HERE

Based on the multiples of the comparable companies, the range of equity values can be

calculated. The equity value varies from USD 27 million to USD 73 million . The lowest values

are shown for the multiples of company D, and the highest are found for company C. In my

example, the market assigns the highest multiples to C except for the sales multiple, despite a

5
currently lower level of profitability in terms of current margins and rate of returns (Table 1).

This might be caused by expectations about a higher level of profitability in the future.

Because the large variation is inadequate, we need to narrow the range. The first step on that

path is the aggregation to an average value.

AGGREGATION TO A PEER GROUP AVERAGE

Table 4 shows company-specific multiples and average values. Alongside the weighted and

arithmetic (unweighted) averages, the median and harmonic mean are presented. The median

is less prone to outliers. However, for a small sample, such as mine, the median is not helpful.

It does not make sense to drop two of the three observations because they are not the median

value. Table 4 also contains the harmonic mean, which is the reciprocal of the arithmetic mean.

The harmonic mean has some useful properties: Multiplying net income of the company being

valued by the PE ratio is equivalent to dividing net income by the reciprocal of the PE ratio, of

course. Using the formula for valuing a perpetuity (Equation 1), also known as the Gordon

growth formula of the Dividend Discount Model (DDM) if we assume that earnings equal

dividends, it becomes apparent that the reciprocal of the multiple equals the discount rate for

capitalizing these earnings minus the growth rate.

Earnings
V= (1)
Discount rate − growth rate

Therefore, valuing a company by multiples is comparable to a capitalization of earnings

assuming that earnings remain constant (or increases by a constant growth rate) and that the

average difference between discount rate and growth rate for the comparable companies

matches the difference for the company to be valued.

6
Coming back to aggregating the PE ratios of the peers, the aggregation should focus on the

reciprocal of the PE ratio, which represents the denominator of (1). As Table 3 and Table 4

illustrate, there is a difference between the average PE ratio and the average inverse PE ratio.

Before moving on, it should be clarified why this is the case:

The function of the reciprocals of the PE ratios (PE-1) is convex. The secant line between two

points of a convex function lies above the function itself. The arithmetic average lies on the

secant line. Therefore, the arithmetic average of the PE ratios is always higher than the average

value based on reciprocals that lies on the function itself. This relationship and the conclusion

of interest here ‘the average of the reciprocals exceeds the reciprocal of the average’ is known

as Jensen's inequality (see, for example, Agrrawal et al. 2010).

In line with Jensen’s inequality, the average of the inverse PE ratios of companies B, C, and D

is 0.1101. The inverse of 0.1101 is 9.079, which is the harmonic mean of the PE ratios. It is

lower than the arithmetic average of the PE ratios, 10.374.

1 1 1 1 
Unweighted average PE −=
1  + + 
3  M PE,B M PE,C M PE,D 
1 1 1 1 
=  + + = 0.1101;
3  9.762 15.195 6.166  (2)

−1
= =
HM PE 0.1101 9.079.

Figure 2 illustrates Jensen’s inequality and its implications for averaging the PE ratios of

companies B, C, and D (see Schwetzler (2003) for a similar illustration). The convex function

relates inverse PE values (x-axis), using the harmonic mean, i.e. the average denominator of

(1), to the price for one USD of earnings (y-axis). Thus, the average value for one USD of

earnings should be 9.079. The dotted line above the convex function would lead to the

arithmetic average of 10.374. This is too high, because the convex value function only justifies

a value, i.e. an average PE ratio, of 9.079.

7
INSERT FIGURE 2 HERE

In light of the link to the capitalization of earnings, which uses the average cost of equity minus

the growth rate, the harmonic mean should be used. In addition, the use of the harmonic mean

can be justified empirically as in Liu et al. (2002), although it should be noted that empirically,

the harmonic mean is sensitive to negative outliers. Beatty et al. (1999) point out that the

harmonic mean should lead to better value predictions as the measurement error in earnings is

shown in the denominator of the PE ratios leading to upward biased predictions. The inverse

PE Ratio avoids this problem.

Finally, the use of the harmonic mean can be justified by looking at the surplus and investment

implied, as shown by, for instance, Pratt, Reilly, and Schweihs (2000, 244), or Agrrawal et al.

(2010):

An investor investing USD 1 million in each of the companies B, C, and D is entitled to the

following net income (NI):

Investment

in USD million in B
1 1 1
+
* 8.4 *5.27 + *3.89 =
0.3304 (3)

82 NI B 80
   24
 
No. of shares in million ...C... ...D...
multiplied with
share price B

The investor receives a share of net income according to his stake in the market value of equity.

Market capitalization and net income are derived from Table 1. Total net income attributable

to the investors (0.3304) divided by his investment (3) equals the expected rate of return of

(0.3304/3) = 0.1101. This is the reciprocal of the harmonic mean of the PE ratio: 0.1101-1 =

9.079.

However, if one presumes that the investor plans to achieve a net income of USD 1 million

from each investment, USD 31.112 million need to be invested:

8
 1 1 1 (4)
*82 + *80 + * 24 =
31.112
8.4

  5.27
   3.89
 
Investment in B in USD million: ...C...: ...D...:
9.762 15.195 6.166

Now, the expected rate of return is USD 3 million / USD 31.112 million = 0.0964. The inverse

of this rate of return, 0.0964-1 = 10.37, is equal to the arithmetic average of the PE ratios of

companies B, C, and D. The link between (equation 3) and the usual way to calculate the

arithmetic mean is:

 
 82 80 24 1 1
 + +  = 31.112 * = 10.37 (5)
 
8.4 
5.27 
3.89  3 3
 PE B 9.762 PE C 15.195 PE D 6.166 

We can conclude that by using different concepts for averaging PE ratio, one implicitly

assumes different levels of investment. By using the harmonic mean, one assumes that the same

amount is invested in each of the comparable companies. Using the arithmetic mean implies

an investment necessary to receive the same amount of earnings from each share of B, C, and

D. Because the first assumption is more plausible, the harmonic mean should be used instead

of the arithmetic mean.

INSERT TABLE 3 HERE

As Table 3 shows, due to Jensen’s inequality the use of arithmetic (unweighted) average will

overvalue the valuation subject, Company A. The arithmetic average of each multiple is higher

than the harmonic mean of the multiples. As already pointed out above, the arithmetic average

leads to upward biased results.

That the choice of the averaging approach is relevant is confirmed by the summary in Table 4.

9
INSERT TABLE 4 HERE

Figure 3 shows the corresponding bandwidth of equity values.

INSERT FIGURE 3 HERE

It is evident that my valuation still does not lead to a narrow range of values. The gray bars in

Figure 3 show the range of values using the non-aggregated multiples of comparable

companies. The black highlighted areas represent the value range based on the aggregated

multiples. They do not overlap in my example. My preliminary results do not provide a concise

basis for estimating the maximum price that a buyer would be inclined to pay or the minimum

price a seller would accept. Even if we used only the harmonic mean, the valuation results

depend upon the multiple used.

LINKS BETWEEN DIFFERENT MULTIPLES

In practice, not all multiples are used at the same time. While selecting the appropriate

multiple(s), industry specifics, as well as the empirical explanatory power of different

multiples, and their empirical fit shown, for example, by their coefficient of variation are to be

considered. However, a prerequisite for analyzing the differences in conceptual and empirical

fit it is helpful to develop an understanding about the links between the multiples available for

the valuation at hand.

10
It is known that multiples can be reconciled (see, for instance, Koller et al. 2015, 327; Soffer

and Soffer 2003, 423-427). Nevertheless, to the best of my knowledge no contribution to the

literature discusses the links between all five multiples in detail. An understanding of the

linkages is essential for laying the groundwork for verifying consistency among the multiples

applied. The basic idea can be illustrated for the transition from EV/Sales to EV/EBITDA

multiple. After multiplying with the EBITDA multiple and its reciprocal, it becomes evident

that the EV/Sales multiple equals the product of EBITDA margin and EBITDA multiple:

EV EV EBITDA EV EBITDA EV
= * * = * (6)
Sales Sales EV EBITDA Sales
  EBITDA
EBITDA − margin

Furthermore, it is interesting for practical usage to determine how the succeeding multiple can

be deduced from the preceding one. For the transition from the EBITDA multiple back to the

sales multiple, the EBITDA multiple must be extended analogously by multiplying with the

reciprocal of the sales multiple:

EV EV Sales EV Sales EV
= * * = * (7)
EBITDA EBITDA EV Sales EBITDA
  Sales
reciprocal of
EBITDA − margin
( m−1)

The EV/EBITDA multiple therefore equals the product of the reciprocal of the EBITDA

margin (m-1) and EV/Sales multiple. This idea can be employed for other multiples as well:

- The EV/EBIT multiple is equal to the EV/EBITDA multiple times the reciprocal of (1-

d). The depreciation factor d is defined as depreciation in percent of EBITDA.

EV EV EBITDA EV EBITDA EV
= * * = * (8)
EBIT EBIT EV EBITDA EBITDA (1 − d ) EBITDA

reciprocal of
'1−depreciation factor'

11
 Analogously the EV/EBITDA multiple can be written as the product of (1-d) and

EV/EBIT. The relation can be broken down to the EV/Sales multiple:

EV EV EV
(1 − d ) * m −1 * (1 − d ) *
−1 −1
= = (9)
EBIT EBITDA Sales

- The transition of the EV/EBIT multiple to the PE ratio is more complex because on the

one hand, interest payments and taxes must be considered, and on the other hand, the

altered capital base – equity value instead of entity value – must be accounted for. With

the interest factor z, the equity-to-EV ratio in terms of market values (P/EV) and the

leverage ratio L, we obtain

P P EBIT EV EBIT P EV
= = * * * *
Earnings Earnings EV EBIT Earnings EV EBIT
EBIT P EV
= * *
EBIT − Interest − Tax EV EBIT (10)
−1 EV − F EV
= (1 − z ) * (1 − τC ) *
−1
*
EV EBIT
EV
= (1 − z ) * (1 − τC ) * (1 − L ) *
−1 −1

EBIT

The PE ratio can be traced back to the ratio of EV/Sales as well, substituting the EBIT

multiple by Equation (8):

P EV
(1 − z ) * (1 − τC ) * (1 − L ) *
−1 −1
=
Earnings EBIT
(11)
EV
= m * (1 − d ) * (1 − z ) * (1 − τC ) * (1 − L ) *
−1 −1 −1 −1

Sales

− The transition of the PE ratio to the PB ratio is less demanding because the latter equals

the product of PE ratio and ROE:

12
 P P Earnings P Earnings P
= * * = * (12)
BEK BEK P Earnings BEK Earnings
 
ROE

Knowing the linkages between different multiples is useful because it highlights the

components of a multiple. If the EV/Sales, EV/EBITDA, and EV/EBIT multiple are used

simultaneously, the implied EBITDA margin, EBIT margin, or expense ratios can be compared

to historical observations or to competitors’ data. Furthermore, based on a preceding multiple,

such as EV/Sales, succeeding multiples can be determined based on margins. Overall, the

possibilities for checking the transparency and plausibility of a valuation using multiples are

increased.

TOP-DOWN VS. BOTTOM-UP DERIVATION OF MULTIPLES

Unfortunately, for the analyst using multiples, a multiple depends upon the way it is calculated.

Table 5 shows that it matters whether a multiple is calculated in one-step (top-down) or in

several steps (bottom-up) by starting from other multiples based upon the links discussed

above. If the EV/EBITDA multiple is derived following Equation (7) by multiplying the

inverse of the EBITDA margin (unweighted average 7.825) with the average EV/Sales multiple

(0.791, see Table 3), we obtain a multiple of 6.191 and an equity value of USD 58.91 million

instead of a multiple of 5.711 and an equity value of USD 54.11 million. The equity value

follows from subtracting net debt from enterprise value.

INSERT TABLE 5 HERE

13
As a result, new valuation estimates emerge and prolong the list of possible results. The PE

multiple, for example, can be derived directly by using market capitalization and net income

of the peer group companies B, C, and D or by employing the modular approach starting with

the preceding multiple and deriving the PE multiple employing margins and expense ratios.

What is the reason for the deviations? The definition of the covariance answers that question:

The covariance of two variables X and Y equals the difference between expected value of Y

times the expected value of X and the expected value of Y times X:

σ=
XY E [ XY ] − E [ X ] * E [ Y ] (13)

E [ XY ] E [ X ] * E [ Y ] + σXY
= (14)

Equation (14) results by applying Equation (13) to the relation between the EV/Sales multiple

and EV/EBITDA multiple as in Equation (6). The covariance between EBITDA margin and

EV/EBITDA multiple equals -0.024.

E [ EV / Sales ] E [ m ] * E [ EV / EBITDA ] + σm; EV/EBITDA

=

  + ( −0.024 )
= 0.1428*5.711 (15)
0.815
= 0.791

The average EBITDA margin (0.1428, see Table 1) multiplied by the average EV/EBITDA

multiple (5.711, see Table 5) plus the covariance (-0.024) confirms the average EV/Sales

multiple (0.791, see Table 3). A covariance different from zero signals that the components of

14
the EV/Sales multiple of the comparable companies are not independent of each other. The

analogous transition from EV/Sales multiple to EV/EBITDA multiple is

E [ EV / EBITDA ] E  m −1  * E [ EV / Sales ] + σ m−1 ; EV/Sales

=

 + ( −0.480 )
−1
= 0.1278  *0.791 (16)
6.191
= 5.711

PRELIMINARY RESULTS

The stepwise process of the bottom-up approach increases the transparency and verifiability of

the valuation. It clarifies that comparability does not end, but rather starts with comparability

in terms of the surplus used. It also makes clear that different combinations of components

might exist that lead to the same or similar multiple values.

A technical result derived above is that top-down and bottom-up approach result in identical

multiples producing identical valuation results only if the components are independent of each

other (covariance: 0). In addition, the granularity of the stepwise bottom-up approach, i.e., the

number and length of the steps, is value relevant. Although the links illustrated by Equations

(6) to (12) work in case of a company on a stand-alone basis, they do not provide unanimous

valuation results for the peer group multiples, as the discussion in the preceding section has

shown. Figure 4 shows for the data of the example, that the value range defined by different

valuation approaches (black bars) is wider than it was in Figure 3.

INSERT FIGURE 4 HERE

15
The interval of aggregated values (black bars) depends on the definition of the average value,

which was also true for the results shown in Figure 3. In addition, the level of aggregation

matters. In the following, I will only use the harmonic mean due to its superiority.

The position of the value intervals is determined by the deviation of the components implied

by the multiple for company A from those for the peer group. The following observations hold

for the example:

- Equity values based on the average EV/EBITDA multiples (black bars) surpass the

values derived with the EV/Sales multiple because the EBITDA margin of company A

(20%) exceeds the average margin of the peer group companies (unweighted average:

14.28%). Table 4 confirms this observation. Because the EV/Sales multiple does not

account for the higher profitability of company A, the value measured by the

EV/EBITDA multiple provides a more reliable result. In line with Equation (6), this

could be illustrated by multiplying the peer group EV/EBITDA ratio, for example, the

unweighted mean of 5.711, by the EBITDA margin of A (20%). One receives an

adjusted EV/Sales multiple for A of 1.142; after multiplication by the sales of A, (50)

results in an enterprise value A of USD 57.11 million (equity value of USD 54.11

million), which is equal to the result delivered by the EBITDA multiple. Thus, the

adjusted bottom-up sales multiple fits to the EBITDA margin of company A.

- The EV/EBIT based interval shows higher company values than the EV/EBITDA based

interval because the depreciation factor of A (30%) is smaller than that of the peer group

(the unweighted average equals 34.6%). Therefore, the reciprocal of (1-d), which is

necessary for linking EV/EBITDA and EV/EBIT, is smaller. That the use of the

EV/EBIT multiple leads to a higher entity value of A than the use of the EV/EBITDA

16
 multiple (see Table 4) can also be shown by rearranging Equation (7) and employing

the firm specific depreciation factor of A:

EV EV
(1 − d A )
= (1 − 0.3) 8.787 =
= 6.151
EBITDA A EBIT Peer Group

The EBITDA of A (10) multiplied by the adjusted EV/EBITDA multiple of 6.151

results in an entity value of A of USD 61.51 million, such as the EV/EBIT multiple

(Table 4).

- For the transition of the EV/EBIT multiple to the PE ratio (Equation 9) interest

payments, taxes and leverage ratio are to be considered. Interest in percentage of EBIT

is smaller for company A (2%) as it is for the peer group (unweighted mean: 14.81%).

Therefore, the reciprocal of (1-z) is smaller. All else being equal, this would result in a

PE-based sub-interval right to the EV/EBIT interval because the earnings of A are less

reduced by interest expenses and are therefore higher than the average PE ratio implies.

The tax rate does not cause value differences here because it is the same for company

A and the peer group tax rate (30%). Unlike the tax rate, the leverage ratio cannot be

assumed to be identical. Accounting for the difference in the leverage ratio is more

challenging. The leverage ratio is 31.72% for the peer group, but the ratio for company

A is not known from the beginning, as the entity value and the value of equity are not

known, but the valuation results are. A circularity problem emerges. In light of the

valuation results for A based on EV/EBIT multiples, as stated in Table 4, one can

conclude that the leverage ratio of A must be considerably smaller than 31.72% because

the value of debt is very small in relation to the entity value. All else being equal, this

effect results in a shift of the estimated values to the left, as the value increasing effect

of the lower interest component is dominated by the value decreasing effect of the lower

leverage ratio. The range of equity values based on the PE ratio is smaller than the value

17
 range according to the EV/EBIT multiple. Stated differently, as the leverage ratio of

the peer group surpasses the leverage ratio of A, too much debt is assigned to company

A by using the PE ratio. This distortion can be avoided if multiples based upon total

company value (EV or MVIC multiples) are used.

Thus far, in accordance with common practice, I have neglected the impact of tax

shields caused by debt financing. In the last section, I address that problem.

- The values estimated by the PB ratio are smaller than the values based on the PE ratio,

as the return on equity of A (20%) exceeds the ROE of the peer group (unweighted

mean: 16.75%). This is the consequence of the rather low book value of equity of

company A, which, after being multiplied by the rather low peer PB ratio, leads to a

low estimate of equity value. The lower book value of company A could be caused, for

example, by intangible assets if their value is not fully captured by the book value. Put

differently, the lower peer group ROE leads to a PB ratio that is too low for A. An

adjusted PB ratio that avoids this problem can be written according to Equation 12

based on the unweighted mean of the PE ratio of 10.374:

P P
= ROE=A* = 2.077
0.2002*10.3744
BEK E

The book value of equity of A (24) multiplied by the adjusted PB ratio of 2.077 results

in a market value of equity of USD 49.85 million, like the PE ratio does (Table 4).

Value estimates that are built upon more specific multiples, such as EBIT multiples, reflect the

characteristics of the company being valued rather than simpler multiples such as sales

multiples. Splitting up a multiple into its components can explain differing valuation results

and enables the derivation of reconciled multiples, which can be adjusted to the specifics of the

company to be valued. Therefore, a sales multiple adjusted to the margin of the company to be

18
valued or an EBITDA multiple adjusted to the depreciation factor can be derived. The PE ratio

is distorted if the capital structure of the company to be valued differs significantly from the

capital structure of its peers. We address that problem in the last section. The PB ratio is

distorted by differences in profitability, as measured by ROE. Avoiding that problem requires

the use of an adjusted PB ratio. Because this only confirms the results obtained by applying the

PE ratio, the use of the adjusted PB ratio is inefficient and unnecessary. The sales multiple

adjusted for differing margins and the EBITDA multiple adjusted for differing depreciation

factors also suffer from that weakness.

INSERT FIGURE 5 HERE

In summary, the value of the equity of company A still ranges from USD 33.7 million to USD

56.4 million. Differences in value occur due to alternative approaches in determining the

average peer group multiple, and due to the choice between the top-down and the bottom-up

approach. It should be noted that the range of values would be even broader if all possible

variations have been considered. Examples for additional alternatives could be developed

based on the direction of the transition (e.g., not only from the EV/Sales multiple to the

EV/EBITDA multiple but also from the EV/EBITDA multiple to the EV/Sales multiple) and

the use of other measures for the aggregation of the components (weighted mean, median,

harmonic mean). Fortunately, the resulting broad range of equity values can be narrowed. As

stated above, the sales multiple does not account for the above-average margin of company A,

but the EBITDA multiple does. The EBIT multiple accounts for the different deprecation ratio

additionally. The PE ratio is distorted by the difference in leverage between the peer group and

company A. Because the PB ratio builds upon ROE, it is also affected by the leverage effect

and, thus, by differing leverage ratios. The difference between ROE and the cost of equity in

19
 the numerator of that equation may be appealing economically. However, it is distorted by

differences in profitability between the company to be valued and its peers.

DEALING WITH DIFFERING CAPITAL STRUCTURES

Valuing equity by the Adjusted-Present-Value (APV) method, a variation of the DCF

approach, requires estimating the enterprise value of the unlevered company (EVU) first. The

unlevered enterprise value is adjusted to reflect the influence of debt financing by adding the

present value of tax shields (VTS). This sum equals the enterprise value and reflects debt

financing (EV). After subtracting debt, we obtain the value of equity. To use that idea for a

multiple-based valuation following Holthausen and Zmijewski (2012), the value of the

unlevered enterprise must be calculated for all peer companies. The estimated present value of

the tax shields must be subtracted from the sum of the market capitalization and debt for that

purpose. Because a multiple refers to a perpetuity, periodic tax shields can also be considered

constant. Thus, the value of the tax shields is simply the tax rate multiplied by debt employed.

The unlevered enterprise value of company B, for example, is

EV = Market value of equity + debt

= USD 82 million + USD 30 million = USD 112 million
(17)
EV=
U EV − V=
TS EV − τC * D
= USD 112 million − 0.25* USD 30 million = USD 104.5 million

EVU/EBITDA and EVU/EBIT multiples are defined analogously. The unlevered version of the

PE ratio is the ratio of EVU to unlevered net income (EBIaT), defined as EBIT multiplied by

the factor (1-τC). I refer to all multiples based upon unlevered enterprise values as unlevered

multiples. These multiples can be applied to the surplus of the company being valued

(EBITDA, EBIT, or EBIaT), resulting in the unlevered EV of company A. Adding the

20
 estimated value of the tax shields of A and subtracting the debt of A leads to the value of equity

of A:

EVU / EBIaTHM = 10.823

=
EBIaTA EBITA (=
1 − τA ) USD 7 million (1 − 0.3) = USD 4.9 million
= =
EVU,A USD 4.9 million *10.823 USD 53.03 million
EVA = EVU,A + VTS,A = USD 53.03 million + 0.3 * USD 3 million = USD 53.93 million
=
E A EVA − D A USD 53.93 million − USD 3 million = USD 50.93 million
=

(18)

Table 6 shows the results for the other multiples.

INSERT TABLE 6 HERE

The resulting bandwidths are shown by Figure 6.

INSERT FIGURE 6 HERE

Although value estimates still vary for the unlevered multiples, the remaining deviation is small

and can be explained in a straightforward manner: The lower value estimates based on the

EVU/EBITDA multiple are caused by the lower depreciation rate of A in comparison to the

peer group. The differing tax rates cause the difference between the value range according to

EVU/EBIT and EVU/EBIaT. In case of uniform deprecation ratios and tax rates, the application

of all three multiples result in the same range of values. The unlevered enterprise value amounts

21
to 10.823 times USD 4.9 million = USD 53.03 million and an equity value of USD 50.93

million.

The results are not distorted by differences in the capital structure between the company to be

valued and its peers.

CONCLUSION

Financial analysts regularly use multiples derived from comparable companies to value other

companies in a similar industry or line of business. The analyst should be prepared to check

the plausibility and consistency of a multiple-based valuation despite the remaining well-

known challenges, such as identifying comparable companies and the implied assumptions of

a perpetuity. The paper shows that the aggregation of the multiples of comparable companies

should be based on the harmonic mean. This conclusion can be justified empirically and

conceptually. The harmonic mean avoids the upward bias of the arithmetic average and implies

an equal contribution of each peer company to the mean. Analyzing the relationships between

multiples employed and their reconciliation can increase transparency and serve as a means for

evaluating the consistency of the conceptual alternatives. These alternatives inherent in using

multiples (the choice between different definitions of the average peer group multiple, the

choice between top-down and bottom-up approach, and the choice between using levered or

unlevered multiples) leads to a considerable bandwidth of equity values. Using a numerical

example, the paper demonstrates how to narrow down this bandwidth. Differences in capital

structure between the comparable companies and the company being valued can be avoided by

using unlevered APV based multiples.

22
23
REFERENCES

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Holthausen, Robert W., and Mark E. Zmijewski. 2014. Corporate Valuation: Theory, Evidence

& Practice. Cambridge.

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____. 2012. “Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and

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25
 TABLES AND FIGURES

Comparable companies
Company Unweighted
A B C D average
Market value of equity 82.0 80.0 24.0 62.0
Debt 3.0 30.0 18.0 24.0 24.0
Enterprise value (EV) 112.0 98.0 48.0 86.0
Leverage ratio (L) = debt divided by EV 26.8% 18.4% 50.0% 31.72%
1-L 73.2% 81.6% 50.0% 68.28%
Book value of equity 24.0 46.0 42.0 20.0 36.0
Cost of debt 4.5% 6.0% 5.0% 6.0% 5.7%
Levered cost of equity (rL) 10.0% 9.0% 14.0% 11.0%
WACC 8.53% 7.94% 9.10% 8.5%

Sales 50.0 100.0 150.0 80.0 110.0

EBITDA 10.0 21.0 14.0 10.0 15.0
EBITDA margin (m) as percentage of sales 20.0% 21.00% 9.33% 12.50% 14.28%
Depreciation 3.0 8.0 5.0 3.0 5.3
Depreciation factor (d) as percentage of EBITDA 30.00% 38.10% 35.71% 30.00% 34.60%
EBIT 7.0 13.0 9.0 7.0 9.67
EBIT margin as percentage of sales 14.0% 13.00% 6.00% 8.75% 9.25%
Interest 0.14 1.80 0.90 1.44 1.38
Interest as percentage of EBIT (z) 1.93% 13.85% 10.00% 20.57% 14.81%
EBT 6.87 11.20 8.10 5.56 8.29
Tax rate (τC) 30.0% 25.0% 35.0% 30.0% 30.00%
Taxes 2.06 2.80 2.84 1.67 2.43
Earnings 4.81 8.40 5.27 3.89 5.85
ROE = earnings divided by book value of equity 20.0% 18.3% 12.5% 19.5% 16.75%
Earnings before interest after adjusted taxes (EBIaT) 4.90 9.75 5.85 4.90 683.33%
ROA = EBIaT divided by equity plus debt 18.1% 12.8% 9.8% 11.1% 11.24%
Table 1: Data in USD million

26
 Multiples derived by the data Equity value estimate in USD million for
of the comparable companies company A
based on multiples for B, C, and D
B C D B C D
EV/Sales 1.120 0.653 0.600 53.00 29.67 27.00
EV/EBITDA 5.333 7.000 4.800 50.33 67.00 45.00
EV/EBIT 8.615 10.889 6.857 57.31 73.22 45.00
PE 9.762 15.195 6.166 46.91 73.02 29.63
PB 1.783 1.905 1.200 42.78 45.71 28.80
Table 2: Value estimates based on multiples of company B, C, and D

Comparable companies Peer Group

Unweighted Weighted Harmonic
B C D average average Median mean
EV/Sales 1.120 0.653 0.600 0.791 0.782 0.653 0.733
EV/EBITDA 5.333 7.000 4.800 5.711 5.733 5.333 5.569
EV/EBIT 8.615 10.889 6.857 8.787 8.897 8.615 8.481
PE 9.762 15.195 6.166 10.374 10.594 9.762 9.079
PB 1.783 1.905 1.200 1.629 1.722 1.783 1.563
Table 3: Company specific and average multiples

Unweighted Weighted
average average Median Harmonic mean
Enterprise Value A
EV/Sales 39.56 39.09 32.67 36.67
EV/EBITDA 57.11 57.33 53.33 55.69
EV/EBIT 61.51 62.28 60.31 59.37
PE 52.85 53.91 49.91 46.63
PB 42.10 44.33 45.78 40.51
Equity Value A
EV/Sales 36.56 36.09 29.67 33.67
EV/EBITDA 54.11 54.33 50.33 52.69
EV/EBIT 58.51 59.28 57.31 56.37
PE 49.85 50.91 46.91 43.63
PB 39.10 41.33 42.78 37.51
Table 4: Valuation estimates for different aggregation methods in USD million

27
 Enterprise Equity value
Unweighted value A in A in USD
average USD million million
EV/EBITDA (one step) 5.711 57.11 54.11
to EV/EBITDA from EV/Sales
m-1 * EV/Sales 6.191 61.91 58.91
EV/EBIT (one step) 8.787 61.51 58.51
to EV/EBIT from EV/Sales
m-1 * (1-d)-1 * EV/Sales 9.491 66.44 63.44
-1
[m * (1-d)] * EV/Sales 9.437
... from EV/EBITDA
(1-d)-1 * EV/EBITDA 8.756 61.29 58.29
PE ratio (one step) 10.374 52.85 49.85
to PE ratio from EV/Sales
m-1 * (1-d)-1 * (1-z)-1 * (1- τC)-1 * (1-L) * EV/Sales 10.934 55.54 52.54
...from EV/EBITDA
(1-d)-1 * (1-z)-1 * (1- τC)-1 * (1-L) * EV/EBITDA 10.087 51.47 48.47
... from EV/EBIT
(1-z)-1 * (1- τC)-1 * (1-L) * EV/EBIT 10.123 51.64 48.64
PB ratio (one step) 1.629 42.10 39.10
to PB ratio from EV/Sales
m-1 * (1-d)-1 * (1-z)-1 * (1- τC)-1 * (1-L) * ROE *
EV/Sales 1.832 46.96 43.96
... from EV/EBITDA
(1-d)-1 * (1-z)-1 * (1- τC)-1 * (1-L) * ROE *
EV/EBITDA 1.690 43.55 40.55
... from EV/EBIT
(1-z)-1 * (1- τC)-1 * (1-L) * ROE * EV/EBIT 1.696 43.70 40.70
... from PE ratio
ROE * PE ratio 1.738 44.71 41.71
Table 5: Multiples derived directly or starting from other multiples (bottom-up approach)

Harmonic
Multiples B C D
mean

EVU/EBITDA 4.976 6.550 4.080 5.011

EVU/EBIT 8.038 10.189 5.829 7.612

EVU/EBIaT 10.718 15.675 8.327 10.823

28
 Value of equity Harmonic
B C D
for company A mean

EVU/EBITDA 47.66 63.40 38.70 48.01

EVU/EBIT 54.17 69.22 38.70 51.18

EVU/EBIaT 50.42 74.71 38.70 50.93

Table 6: Valuation estimates based on unlevered APV based multiples in USD million

D C B
EV/Sales

D B C
EV/EBITDA

D B C
EV/EBIT

D B C
PE-Ratio

D B C
Price-Book-Ratio

25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75

Figure 1: Range of estimated values of equity in USD million employing multiples of companies B, C, and D

29
Figure 2: Illustrating Jensens’s inequality and the implications for the average PE ratio

Figure 3: Range of estimated values of equity in USD million employing different methods for aggregating peer group

multiples (minimum and maximum values of the gray bars: derived from Table 2; black bars: from Table 4. HM

stands for harmonic mean; MD: median; UA: unweighted average; WA: weighted average)

30
Figure 4: Range of estimated values of equity in USD million using different averages, and top-down and bottom-up

approach (minimum and maximum values of the gray bars: derived from Table 2; black bars: Table 4 and Table 5.

HM stands for harmonic mean; MD: median; UA: unweighted average; WA: weighted average)

31
 Figure 5: Range of estimated values of equity in USD million (minimum and maximum values of the gray bars:
derived from Table 2; highlighted values: harmonic means (HM) according to Table 4, Table 5)

Figure 6: The final range of values of equity in USD million based on unlevered multiples

32

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