Equity Valuation Using Multiples: An Empirical Investigation DISSERTATION of the University of St.Gallen Graduate School of Business Administration, Economics, Law and Social Sciences (HSG) to obtain the title of Doctor of Business Administration submitted by Andreas Schreiner from Austria Approved on the application of Prof. Dr. Klaus Spremann and Prof. Dr. Thomas Berndt Dissertation no. 3313 Deutscher Universitäts-Verlag, Wiesbaden 2007 The University of St. Gallen, Graduate School of Business Administration, Eco- nomics, Law and Social Sciences (HSG) hereby consents to the printing of the pre- sent dissertation, without hereby expressing any opinion on the views herein ex- pressed. St. Gallen, January 22, 2007 The President: Prof. Ernst Mohr, Ph.D. Foreword Accounting-based market multiples are the most common technique in equity valuation. Multiples are used in research reports and stock recommendations of both buy-side and sell-side analysts, in fairness opinions and pitch books of investment bankers, or at road shows of firms seeking an IPO. Even in cases where the value of a corporation is primarily determined with discounted cash flow, multiples such as P/E or market-to-book play the important role of providing a second opinion. Mul- tiples thus form an important basis of investment and transaction decisions of vari- ous types of investors including corporate executives, hedge funds, institutional in- vestors, private equity firms, and also private investors. In spite of their prevalent usage in practice, not so much theoretical back- ground is provided to guide the practical application of multiples. The literature on corporate valuation gives only sparse evidence on how to apply multiples or on why individual multiples or comparable firms should be selected in a particular context. The present book by Andreas Schreiner develops a comprehensive multiples valuation framework, which overcomes many of these problems. It gives answers to many questions, which have not been clarified so far, and which must be addressed in order to come up with sound and convincing valuations in practice. After an in- troduction and a review of the literature, Schreiner outlines the theoretical founda- tions of equity valuation using multiples. He derives intrinsic multiples from fun- damental equity valuation models and explains why some firms deserve higher or lower multiples than its peers. Based on the weaknesses of the standard multiples valuation method, Schreiner systematically develops a list of criteria for the selec- tion of relevant multiples and the identification of comparable firms. The introduc- tion of an adjustment factor in the valuation equation offers a solution to the ques- tion, how to account for strategic advantages of the firm being valued over the peer group. Then, a two-factor multiples model is presented to combine information pro- vided by two different multiples into a single valuation equation. The book enriches the research on multiples with an extensive empirical study of European and U.S. equity markets. The results of the study, which exhibit high significance and robustness, approve the relevance of the multiples valuation IV Foreword framework. Schreiner demonstrates quite a number of results such as (1) the use of market capitalization as market price variable in the numerator of a multiple; (2) the consideration of knowledge-related variables in science-based industries; (3) the incorporation of forward-looking information; and (4) the usage of a preferably fine industry definition. For a selection of five key industries, Schreiner finds empirical support for the existence of industry-preferred multiples when using trailing multi- ples and for the usefulness of the two-factor model. With his work, Andreas Schreiner makes an influential contribution to the the- ory and practice of corporate valuation using multiples. The straightforwardness of the underlying framework and the empirical results make the book an important reference for practitioners. I recommend this book to professionals in corporate fi- nance and equity research, and wish that it wins the broad readership it deserves. Dr. Klaus Spremann Professor and Director Swiss Institute of Banking and Finance Preface Reviewing my time as a research associate makes me feel as if a dream had turned into reality. This dream combined unique learning experiences on both an academic and a personal level with full enjoyment and diversity of life. Within the dream, there have been many people, whom I want to thank for helping me in one way or the other during the last three years. Foremost my deepest gratitude goes to Professor Klaus Spremann, my advisor and academic teacher. He gave me the re- quired inspiration and guidance to explore my potentials and utilize them in this book. My working experience with him as an assistant and as a research associate at the Swiss Institute of Banking and Finance at the University of St.Gallen exceeded all my expectations: he taught me the economics of corporate finance and portfolio management in his books and seminars as well as in our conversations and meet- ings. I learned from him to approach challenging tasks with the right attitude and experienced what it means to grow with confidence and responsibility. Profound gratitude also goes to Professor Thomas Berndt, who spontaneously agreed to supervise my work as a co-adviser. His enthusiasm and thoughts sparked my interest in many areas of accounting and made him a great mentor. Likewise, I am very grateful to Professor Pascal Gantenbein. He initiated my passion for the world of finance when I arrived as a master student at the University of St.Gallen in 2004, and since then advised, encouraged, and supported me at any time in various aspects of life. Within the twelve-month period as a visiting researcher at the Anderson School of Management at UCLA and the Yale School of Management in 2006/2007, the quality and substance of my research gained enormously from the faculty input I received from Professor Jing Liu, Professor David Aboody (both UCLA), and Professor Jacob Thomas (Yale). Special thanks also goes to Dean Al Osborne, Dean Eric Mokover (both UCLA), and Professor Subrata Sen (Yale) for making this unforgettable experience possible. Financial support for this research visit by the Swiss National Science Foundation is gratefully acknowledged. Changing environments and the speed of life pose a challenge for friendships and relationships. Notwithstanding, I enjoyed grand benevolence and encourage- VI Preface ment from my friends, which I deeply appreciate. Sebastian Lang, Jan Bernhard, Andreas Zingg, and several other colleagues at the Swiss Institute of Banking and Finance were always available to share thoughts and provide feedback. My work also benefited from conversations with students of the Doctoral and the MAccFin program at the University of St.Gallen, in particular with John von Berenberg- Consbruch, whom I supervised with his master thesis. Similarly, I received helpful comments from Ph.D. students at the finance department at UCLA, notably Yuzhao Zhang, and Ph.D. students at the School of Management at Yale, notably Panagiotis Patatoukas. Philipp Hirzberger, Ralph Huber, Phillip Kirst, Kay Oppat, Martin Pansy, and many other friends supported me by providing the necessary mental balance at all times in Switzerland and back home in Austria. Toni Schmidt, Tobias Baumann, András Kadocsa, Tim Malonn, and Saskia Pfauter in Los Angeles as well as Tatiana Alekseeva and Christoph Lassenberger in New Haven, together with many friends visiting me from Europe, in particular Michael Pucher and Kerstin Stockinger, joined me to explore the beauties and leisure opportunities of the American East and West Coast. Mike Finley carefully proofread the manuscript on grammar and style issues. However, all remaining deficiencies and errors are mine. Finally, I thank my parents Johannes and Renate Schreiner, together with my sister Julia. Their love and patience is what I always rely on. St. Gallen, January 22, 2007 Andreas Schreiner Executive summary This book is motivated by the apparent gap between the widespread usage of multiples in valuation practice and the deficiency of relevant research related to multiples. While valuing firms using multiples seems straightforward on the sur- face, it actually invokes several complications and open issues. To close this gap, the book examines the role of multiples in equity valuation and transforms the stan- dard multiples valuation method into a comprehensive framework for using multi- ples in equity valuation. To identify the underlying drivers of different multiples, I derive intrinsic mul- tiples from fundamental equity valuation models. An overview of common market multiples and the standard multiples valuation method including its criticism initi- ates an in-depth analysis of every single step of the four-step multiples valuation process. I investigate key criteria for the selection of value relevant measures and for the identification of comparable firms, and assess the usefulness of a two-factor multiples valuation model combining book value and earnings multiples from a theoretical point of view. In the empirical study, I find that multiples generally approximate market val- ues reasonably well. In terms of relative performance, the results show that: (1) eq- uity value multiples outperform entity value multiples; (2) knowledge-related mul- tiples outperform traditional multiples in science-based industries; and (3)