The Anatomy of a Multiple

Why relative valuation?

"If you think Iím crazy, you should see the guy who lives across the hall"

Jerry Seinfeld talking about Kramer in a Seinfeld episode

"A little inaccuracy sometimes saves tons of explanation"

H.H. Munro

What is relative valuation?

• In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets.
• To do relative valuation then,
• we need to identify comparable assets and obtain market values for these assets
• convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price multiples.
• compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or over valued

Standardizing Value

• Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues.
• Earnings Multiples
• Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
• Value/EBIT
• Value/EBITDA
• Value/Cash Flow
• Book Value Multiples
• Price/Book Value(of Equity) (PBV)
• Value/ Book Value of Assets
• Value/Replacement Cost (Tobinís Q)
• Revenues
• Price/Sales per Share (PS)
• Value/Sales
• Industry Specific Variable (Price/kwh, Price per ton of steel ....)

The Four Steps to Understanding Multiples

• Define the multiple
• In use, the same multiple can be defined in different ways by different users. When comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated
• Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low.
• Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple, and the nature of the relationship between the multiple and each variable.
• Apply the multiple
• Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.

Definitional Tests

• Is the multiple consistently defined?
• Proposition 1: Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value.
• Is the multiple uniformally estimated?
• The variables used in defining the multiple should be estimated uniformly across assets in the ìcomparable firmî list.
• If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets. The same rule applies with book-value based multiples.

Descriptive Tests

• What is the average and standard deviation for this multiple, across the universe (market)?
• What is the median for this multiple?
• The median for this multiple is often a more reliable comparison point.
• How large are the outliers to the distribution, and how do we deal with the outliers?
• Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate.
• Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple?
• How has this multiple changed over time?

Analytical Tests

• What are the fundamentals that determine and drive these multiples?
• Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns.
• In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple
• How do changes in these fundamentals change the multiple?
• The relationship between a fundamental (like growth) and a multiple (such as PE) is seldom linear. For example, if firm A has twice the growth rate of firm B, it will generally not trade at twice its PE ratio
• Proposition 3: It is impossible to properly compare firms on a multiple, if we do not know the nature of the relationship between fundamentals and the multiple.

Application Tests

• Given the firm that we are valuing, what is a "comparable" firm?
• While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals.
• Proposition 4: There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics.
• Given the comparable firms, how do we adjust for differences across firms on the fundamentals?
• Proposition 5: It is impossible to find an exactly identical firm to the one you are valuing.