MARKET-BASED

VALUATION:
PRICE AND ENTERPRISE
VALUE MULTIPLES

Presenter
Venue
Date
 VALUATION INDICATORS

Price
Multiples

Enterprise
Value
Multiples
Example 1 p383
 METHODS FOR PRICE AND ENTERPRISE
VALUE MULTIPLES

1. Method of Comparables
• Economic rationale is the law of one price

2. Method Based on Forecasted Fundamentals

• Reflects firm fundamentals and future cash flows

3.Justified Price Multiples

• Can be determined using either method
Summary of Ratios related to Stock Price
Method of Comparables

EXAMPLE
Method of Comparables
Method of Comparables
 Price to EBT

EQUITY
 PRICE-TO-EARNINGS MULTIPLE
RATIONALES AND DRAWBACKS

Rationales Drawbacks
Zero, negative, or very
EPS is driver of value
small earnings

Permanent versus
Widely used
transitory earnings

Related to stock Management

returns discretion for earnings
 PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS

Trailing Forward
P/E P/E
Preferred Preferred
Uses last when Uses next when trailing
year’s forecasted year’s earnings are
earnings earnings are earnings not reflective
not available of future
NORMALIZED EPS

High P/Es on depressed EPS at the bottom of the cycle and low P/Es on unusually
high EPS at the top of the cycle reflect the countercyclical property of P/Es known as
the Molodovsky effect
Analysts address this problem by normalizing EPS—that is, estimating the
level of EPS that the business could be expected to achieve under mid-
cyclical conditions (normalized EPS or normal EPS).15 Two of several
available methods to calculate normalized EPS are as follows:
◾ The method of historical average EPS, in which normalized EPS is
calculated as average EPS over the most recent full cycle.
◾ The method of average return on equity, in which normalized EPS is
calculated as the average return on equity (ROE) from the most recent
full cycle, multiplied by current book value per share.
 EXAMPLE: FORWARD P/E
Stock price* $20 .00
2016:Q1 EPS $0 .18
2016:Q2 EPS $0 .25
2016:Q3 EPS $0 .32
2016:Q4 EPS $0 .35
2016 Fiscal year forecast $1 .10

2017:Q1 EPS $0 .43

2017:Q2 EPS $0 .48
2017:Q3 EPS $0 .50
2017:Q4 EPS $0 .59
2017 Fiscal year forecast $2 .00

* Assume we are at the beginning of December 2016.

 EXAMPLE: FORWARD P/E

1) Forward P/E based on EPS for the next four quarters:

EPS for the next four quarters = $0.35 + $0.43 + $0.48 + $0.50 = $1.76

Forward P/E based on EPS for the next four quarters = $20 / $1.76 = 11.4

2) Forward P/E based on EPS for the NTM (next 12 months):

( ) ( )
EPS for the NTM = 1 $1.10 + 11 $2.00 = $1.925
12 12
Forward P/E based on EPS for the NTM = $20 / $1.925 = 10.4
 EXAMPLE: FORWARD P/E

3) Forward P/E based on the current fiscal year's EPS:

EPS for the current fiscal year = $1.10

Forward P/E based on EPS for the current fiscal year = $20 / $1.10 = 18.2

4) Forward P/E based on the next fiscal year's EPS:

EPS for the next fiscal year = $2.00
Forward P/E based on EPS for the next fiscal year = $20 / $2.00 = 10.0
 EXAMPLE: NORMALIZED EARNINGS

Year EPS BVPS ROE

2015 $0.66 $4.11 16.1%
2014 $0.55 $3.67 15.0%
2013 $0.81 $2.98 27.2%
2012 $0.73 $2.12 34.4%
2011 $0.34 $1.61 21.1%

2016 stock price $24.00

 EXAMPLE: NORMALIZED EARNINGS

1) Method of historical average EPS

($0.66 + $0.55 + $0.81 + $0.73 + $0.34)

Average (normalized) EPS = = $0.618
5

P/E = $24.00 / $0.618 = 38.8

 EXAMPLE: NORMALIZED EARNINGS

2) Method of average ROE

(16.1% + 15.0% + 27.2% + 34.4% + 21.1%)

Average ROE = = 22.8%
5

Average (normalized) EPS = Average ROE ´ Current equity book value per share
Average (normalized) EPS = 22.8% ´ $4.11 = $0.937

P / E = $24.00 / $0.937 = 25.6

ISSUES IN CALCULATING EPS

Underlying
EPS Dilution
Earnings

Differences
Normalized
in Accounting
Earnings
Methods
 METHOD OF COMPARABLES

Benchmark Value of the

Multiple Choices

Industry Broad Firm’s

Industry
or sector market historical
peers
index index values
 METHOD OF COMPARABLES
USING PEER COMPANY MULTIPLES

§ Law of one price

§ Risk and earnings growth adjustments
§ PEG limitations:
§ Assumes linear relationship
§ Does not account for risk
§ Does not account for growth duration
 METHOD OF COMPARABLES
USING INDUSTRY AND MARKET MULTIPLES

§Industry or Sector Index

§ Mean vs. median
§ Check industry valuation against market

§Broad Market Index

§ Adjust for differences in fundamentals
and size
§ Use relative values on a historical basis
 USING P/ES FOR TERMINAL VALUE

P/E Based on
Justified P/E
Comparables

P/E = Grounded in market

(D/E)/(r – g) data

If comp is mispriced,
Sensitive to required
terminal value will
inputs
be mispriced

EXAMPLE 17 p 410
 PRICE-TO-BOOK VALUE MULTIPLE
DRAWBACKS

Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Because of Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

 ADJUSTMENTS TO BOOK VALUE

Intangible Inventory
Assets Accounting

Off-Balance-
Fair Value
Sheet Items
 PRICE-TO-SALES
MULTIPLE RATIONALES

Sales Less Easily Manipulated

Sales Are Always Positive

P/S Appropriate For Mature, Cyclical, and Distressed Firms

P/S More Stable Than P/E

Can Explain Stock Returns

 PRICE-TO-SALES
MULTIPLE DRAWBACKS

Sales ≠ Earnings and Cash Flow

Numerator and Denominator Not Consistent

P/S Does Not Reflect Cost Differences

P/S Can Be Misleading Because of Accounting

Practices
 PRICE-TO–CASH FLOW
MULTIPLE RATIONALES

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E

Ratio Can Explain Stock Returns

PRICE-TO–CASH FLOW
MULTIPLE DRAWBACKS

Cash Flow Can Be

Distorted

FCFE More Volatile

and More Frequently
Negative

Cash Flow Increasingly

Managed by Firms
 DEFINITIONS OF CASH FLOW

• Earnings + Depreciation +
CF Amortization + Depletion

CFO • From statement of cash flows

FCFE • Most valid but volatile

• Best used with enterprise

EBITDA value
 ENTERPRISE VALUE/EBITDA MULTIPLE
RATIONALES AND DRAWBACKS

Rationales Drawbacks
Useful for comparing firms
of different leverage Exaggerates cash flow

Useful for comparing firms

of different capital utilization
FCFF more strongly
Usually positive grounded
 ISSUES IN USING ENTERPRISE VALUE
MULTIPLES

EV = Market value of stock + Debt – Cash – Investments

Justified EV/EBITDA
• Positively related to FCFF growth
• Positively related to ROIC
• Negatively related to WACC
Comparables May Use Total Invested Capital

Other EV Multiples
• EV/FCFF
• EV/EBITA
• EV/EBIT
• EV/S
 SUMMARY

Price and Enterprise Value Multiples

• Method of comparables
• Method based on forecasted fundamentals

Price-to-Earnings Rationales and Drawbacks

• Rationales: EPS ® Driver of value, widely used, and

related to stock returns
• Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion for
earnings
• Trailing and forward P/Es
 SUMMARY

Issues in Calculating EPS

• EPS dilution
• Underlying earnings
• Normalized earnings
• Differences in accounting methods

Method of Comparables

• Industry peers
• Industry or sector index
• Broad market index
• Own historical values
 SUMMARY
Price-to-Book Rationales and Drawbacks

• Rationales: Book value usually > zero, more stable than EPS,
appropriate for financial firms and firms that will terminate, and
explains stock returns
• Drawbacks: Doesn’t recognize nonphysical assets, misleading
if asset levels vary or differ from accounting practices, less
useful when asset age differs, and can be distorted by
repurchases

Issues in Calculating Book Value

• Intangible assets
• Inventory accounting
• Off-balance-sheet items
• Fair value
 SUMMARY
Price-to-Sales Rationales and Drawbacks
• Rationales: Sales less easily distorted, sales always
positive, P/S more stable than P/E, appropriate for many
firms, and explains stock returns
• Drawbacks: Sales ≠ Earnings and Cash flow, numerator
and denominator not consistent, does not reflect cost
differences, and can be distorted

Price-to-Cash-Flow Rationales and Drawbacks

• Rationales: CF less easily manipulated, more stable than

P/E, addresses quality of earnings issue, and explains stock
returns
• Drawbacks: can be distorted, FCFE more volatile and more
frequently negative, and increasingly managed by firms
 SUMMARY

Measures of Cash Flow

• CF: Earnings + Depreciation + Amortization + Depletion
• CFO: From statement of cash flows
• FCFE: Most valid but volatile
• EBITDA: Best used with enterprise value

Dividend Yield Rationales and

Drawbacks
• Rationales: A component of return, dividends less risky
than future capital gains
• Drawbacks: Only one component of return, dividends
may displace future earnings, and market may not favor
dividends
 SUMMARY

Enterprise Value Multiples

• EV = Market value of stock + Debt – Cash –

Investments
• Rationales: Useful for comparing firms of
different leverage and capital utilization,
usually positive
• Drawbacks: Exaggerates cash flow, FCFF
more strongly grounded