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Valuation Multiples

Valuation multiples are the quickest way to value a company, and are useful in comparing similar companies (comparable company analysis). They attempt to capture many of a firm's operating and financial characteristics (e.g. expected growth) in a single number that can be mutiplied by some financial metric (e.g. EBITDA) to yield an enterprise or equity value. Multiples are expressed as a ratio of capital investment to a financial metric attributable to providers of that capital.

Exhibit A – Common Valuation Multiples

Enterprise Value Multiples   Equity Value Multiples
 
EV / EBITDA   Price / EPS ("P/E")
EV / EBIT   Equity Value / Book Value
EV / Sales   P / E / Growth ("PEG Ratio")
EV / Unlevered Free Cash Flow    

One very important point to note about multiples is the connection between the numerator and denominator. Since enterprise value (EV) equals equity value plus net debt, EV multiples are calculated using denominators relevant to all stakeholders (both stock and debt holders). Therefore, the relevant denominator must be computed before interest expense, preferred dividends, and minority interest expense. On the other hand, equity value multiples are calculated using denominators relevant to equity holders, only. Therefore, the relevant denominator must be computed after interest, preferred dividends, and minority interest expense.

For example, an EV/Net Income multiple is meaningless because the numerator applies to shareholders and creditors, but the denominator accrues only to shareholders. Similarly, an Equity Value/EBITDA multiple is meaningless because the numerator applies only to shareholders, while the denominator accrues to all holders of capital. With this understanding of the relationship between numerator and denominator, we can invent virtually any multiple we like to value a business, so long as the multiple is, of course, relevant to that business.

The choice of multiple(s) in valuing and comparing companies depends on the nature of the business or the industry in which the business operates. For example, EV/(EBITDA−CapEx) multiples are often used to value capital intensive businesses like cable companies, but would be inappropriate for consulting firms. To figure out which multiples apply to a business you are considering, try looking at equity research reports of comparable companies to see what analysts are using.

Enterprise value multiples are better than equity value multiples because the former allow for direct comparison of different firms, regardless of capital structure. Recall, that the value of a firm is theoretically independent of capital structure. Equity value multiples, on the other hand, are influenced by leverage. For example, highly levered firms generally have higher P/E multiples because their expected returns on equity are higher. Additionally, EV multiples are typically less affected by accounting differences, since the denominator is computed higher up on the income statement.

In practice, we generally refer to some multiples using the denominator only, because the numerator is implied. For example, when talking about the EV/EBITDA multiple, we would simply say "EBITDA multiple", because the only sensible numerator is EV.

Exhibit B – Comments on Various Multiples

Multiple   Comments
 
EV / EBITDA   EV/EBITDA is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm. EV/EBITDA is often in the range of 6.0x to 18.0x.
 
EV / EBIT   When depreciation and amortization expenses are small, as in the case of a non-capital-intensive company such as a consulting firm, EV/EBIT and EV/EBITDA will be similar. Unlike EBITDA, EBIT recognizes that depreciation and amortization, while non-cash charges, reflect real expenses associated with the utilization and wear of a firm's assets that will ultimately need to be replaced. EV/EBIT is often in the range of 10.0x to 25.0x.
 
EV / Sales   When a company has negative EBITDA, the EV/EBITDA and EV/EBIT multiples will not be material. In such cases, EV/Sales may be the most appropriate multiple to use. EV/Sales is commonly used in the valuation of companies whose operating costs still exceed revenues, as might be the case with nascent Internet firms, for example. However, revenue is a poor metric by which to compare firms, since two firms with identical revenues may have wildly different margins. EV/Sales multiples are often in the range of 1.00x to 3.00x
 
P / E   P/E is one of the most commonly used valuation metrics, where the numerator is the price of the stock and the denominator is EPS. Note that the P/E multiple equals the ratio of equity value to net Income, in which the numerator and denominator are both are divided by the number of fully diluted shares. EPS figures may be either as-reported or adjusted as described below. P/E multiples are often in the range of 15.0x to 30.0x.
 
P / E / G   The PEG ratio is simply the P/E ratio divided by the expected EPS growth rate, and is often in the range of 0.50x to 3.00x. PEG ratios are more flexible than other ratios in that they allow the expected level of growth to vary across companies, making it easier to make comparisons between companies in different stages of their life cycles. There is no standard time frame for measuring expected EPS growth, but practitioners typically use a long-term, or 5-year, growth rate.

Calculating the Denominator (EBITDA, Net Income, etc.)

The denominator may be either a stock or a flow. A stock is measured at a single point in time (e.g. book value), while a flow is measured over a period of time (e.g. EBITDA). We will focus our discussion here on flows.

Historical valuation multiples are usually calculated over the last twelve month (LTM) period. To calculate the LTM EBITDA, for example, add the EBITDA from the most recent stub period to the latest full-year EBITDA, and subtract the EBITDA from the corresponding stub period last year. Publicly traded U.S. companies report earnings on a quarterly basis, but many publicly traded foreign firms only report earnings every 6 months on a semi-annual basis. Therefore, it is possible that the LTM periods for some foreign firms will not chronologically align with the LTM periods for U.S. firms.

Example – LTM Calculation

A company's latest 10-K reported EBIT of $100 for the fiscal year ending 12/31/07. The company's latest 10-Q reported EBIT of $80 for the nine months ended 9/30/08 and $70 for the nine months ended 9/30/07. What is the company's LTM EBIT?

LTM EBIT = $100 + $80 − $70 = $110.

Most publicly traded companies are valued based on their projected, rather than historical, earnings and cash flows. Projections, or forward estimates, are made by equity research analyst estimates, and often averaged for use in calculating valuation multiples. Forward estimates can be obtained from sources like Bloomberg, First Call, and IBES. These projections are usually provided on a calendar year basis for consistency, but it is necessary to verify that all such estimates use the same yearly basis (either calendar or fiscal) to make apples-to-apples comparisons.

Adjust the denominator to exclude the effects of extraordinary and non-recurring items such as restructuring charges, one-time gains/losses, accounting changes, legal settlements, discontinued operations, and asset impairment charges. Also, if noncontrolling interest is excluded from the calculation of EV, the portion of EBITDA and EBIT attributable to the noncontrolling interest should also be excluded from the denominator.

When using multiples to compare similar companies in a peer group as part of a comparable companies analysis, it is necessary to ensure that the comparison is "apples-to-apples". This means that the denominators of all multiples compared should span the same time period, whether historical or projected, and be adjusted for the same items, such as stock-based compensation.

Adjusted Earnings

Not all earnings are created equal, as equity research analysts may use either reported earnings or adjusted cash earnings in the calculation of EPS. Adjusted earnings figures often add back non-cash expenses like stock-based compensation, amortization, restructuring charges. When comparing the P/E ratios of different companies, it is very important to be sure that the ratios you are comparing all use either as-reported or cash EPS figures to make an apples-to-apples comparison.

Analysts will often use adjusted EPS figures when adjusted earnings are made available by the company. To see if the company releases adjusted results, check the 8-K filing concerning the most recent earnings release. Then, compare the analyst's figures with reported and adjusted results to determine which is used by the analyst. The analyst's numbers may not match either set of figures, but should be close enough to indicate which set he or she is using.

Unlevered Free Cash Flow

Unlevered free cash flow (UFCF) is the free cash flow attributable to all suppliers of capital (shareholders and debt holders). To calculate UFCF, start with operating income (EBIT). Note that EBIT is an unlevered figure because it is calculated before interest expense. Next, subtract taxes to yield EBIAT [=EBIT×(1−tax rate)]. Then, add back depreciation expense and subtract CapEx and the change in net working capital (NWC).

Forward-Looking vs. Historical Multiples

Empirical evidence shows that forward-looking multiples are more accurate predictors of value than historical multiples.

If you are looking for more information on valuation multiples, check out this pdfexcellent primer published by UBS Warburg.

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