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Valuation Multiples a Reading Prepared by Pamela Peterson Drake James Madison University

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Valuation Multiples a Reading Prepared by Pamela Peterson Drake James Madison University Valuation multiples A reading prepared by Pamela Peterson Drake James Madison University Table of Contents Introduction........................................................................................................................................ 1 Understanding the use of multiples ...................................................................................................... 1 Identifying the comparables ................................................................................................................ 1 Choosing a multiple ............................................................................................................................. 2 Price-earnings ratio .......................................................................................................................... 3 Price-book ratio ............................................................................................................................... 4 Price-sales ratio ............................................................................................................................... 5 Price-cash flow ratio ........................................................................................................................ 6 PEG ratio ......................................................................................................................................... 6 Calculating the multiples .................................................................................................................. 7 Adjusting for differences in accounting ................................................................................................. 7 Applying the multiples ......................................................................................................................... 8 Issues multiples .................................................................................................................................. 8 To average or not to average?.......................................................................................................... 8 Problems with the denominator ........................................................................................................ 9 The Moldovsky effect ..................................................................................................................... 10 Summary .......................................................................................................................................... 12 For further information ...................................................................................................................... 12 Index ............................................................................................................................................... 12 Updated: August 2009 Introduction There are many approaches to valuing a company, a division, or any other business unit, including discounted cash flows methods and valuation multiples. The discounted cash flow methods require estimates of cash flows for a number of periods into the future, a discount rate that reflects the riskiness of these cash flows, and either an assumption regarding the growth rate of cash flows into the future or a terminal or horizon value of the business unit at some point in the future. The valuation multiples require selection of a comparable or comparable businesses units and a multiple or set of multiples for valuation, such as a price-earnings ratio. The focus of this reading is on the valuation multiples approach. Understanding the use of multiples The process of valuation using multiples requires the use of information on comparable firms, some Exhibit 1 Valuation using multiples adjustments to improve comparability, and then the application of the multiple derived from the Identify comparable firms and determine comparable firms to the subject firm, as shown in values from market data Exhibit 1. Adjust values for different accounting This process will lead to an estimate of value for a methods company which is just that: an estimate. As you can see in Exhibit 1, this process involves a great Calculate the multiple based on the deal of guess-work along the way, such that errors comparable firms’ base and values in estimates are compounded. A prudent approach is to use more than one multiple, evaluate the sensitivity of the estimates to the choice of Estimate the base of the multiple for the comparables, and consider the amount of error that subject business unit or company is present in the estimates. Apply the multiple from the comparables Identifying the comparables to the subject business unit or company To make comparisons, the analyst most likely will want to compare the firm with other firms. But identifying the other firms in the same or similar lines of business presents a challenge. A system that has been used for many years for classifying firms by lines of business is the Standard Industrial Classification (SIC) system, which was developed by the Office of Management and Budget. However, starting in 1997, another classification system, North American Industry Classification System (NAICS) replaces SIC codes with a system that better represents the current lines of business. Using the NAICS, we can classify a firm and then compare this firm with other of that class. Classifying firms into industry groups is difficult because most firms have more than one line of business. Most large corporations operate in several lines of business. Do we classify a firm into an industry by the line of business that represents: The most sales revenue generated? The greatest investment in assets? The greatest share of the firm's profits? It is not clear which is the most appropriate method and a firm may be classified into different industries by different financial services and analysts. 1 When identifying comparables, it is important to identify, if possible, companies that are most similar according to a number of dimensions: . Line of business and, specifically, products . Asset size . Number of employees . Growth in revenues and earnings . Cash flow Often, when we evaluate a company that is not publicly-traded, we are comparing a smaller company with larger, publicly-traded companies. Therefore, it is often difficult to match up the subject company with a similar-size company in terms of assets and number of employees. However, matching up on as many factors as possible is useful, especially with respect to the line of business. Consider the 2005 fiscal year data of a company that is the subject of a valuation: Line of business Confectionary Total assets $300 million Book value of equity $200 million Revenues $600 million Earnings $90 million Cash flow from operations $110 million Growth in revenues 7% per year Growth in earnings 9% per year Number of employees 2,500 Now consider publicly-traded companies in the confectionary industry, using fiscal year 2005 values: Hershey Tootsie Roll Wm. Wrigley Total assets $4,295.2 million $813.7 million $4,460.2 million Book value of shareholders’ equity $1,021.1 million $617.4 million $2,214.4 million Revenues $4,836.0 million $487.7 million $4,159.3 million Earnings $493.2 million $77.2 million $517.3 million Cash flow from operations $461.8 million $82.5 million $757.6 million Growth in revenues 5.5% 5.5% 9% Growth in earnings 10% 6.50% 10% Number of employees 40,523 1,950 43,555 Which firm is most comparable? Tootsie Roll is the smallest of the three possible comparables, but is it the most comparable in other dimensions? Should we take an average of the three companies’ values in some way? Should we restrict the comparables to U.S. companies, or should we expand the eligible companies to include Lindt & Sprüngli or Nestlé? While the choice of comparables is important, analysts will also examine the sensitivity of their valuation to the choice of the comparable and develop a range of estimates based on alternative comparables. Choosing a multiple There are a large number of multiples that an analyst can apply in a valuation situation. These multiples include the price-earnings ratio, the price-book ratio, and the price-sales ratio. In addition, we may want to compare PEG ratios as well 2 Price-earnings ratio The price-earnings ratio, also referred to as the PE or P/E ratio, is simply the ratio of the market value of the stock to the earnings or net income: Market value of equity Market value-earnings ratio = Net income We can also restate the price-earnings ratio in the more familiar, but numerically equivalent, per-share basis as the ratio of the price of a share of stock to the earnings per share: Market price per share Price-earnings ratio = Earnings per share But it really is not as simple as that: . Do we use earnings for the most recent four quarters of earnings? This is referred to as the trailing PE. Or do we use forecasted earnings? This is referred to as the leading PE. The most important issue is that you are consistent. When you gather the information for the comparables, you should make sure that the multiples are determined in the same manner and then applied consistently to the subject company. For example, many analysts remove non-recurring items from earnings before calculating this ratio so that we get a better picture of the underlying earnings of a company. When using price-earnings ratios calculated from a third party, it is important to understand how these ratios are calculated: Before or after extraordinary
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