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

- we need to

**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 ....)

- Earnings Multiples

**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__

- In use, the same multiple can be defined in
- 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.

- Too many people who use a multiple have
- 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.

- It is critical that we
- Apply the multiple
- Defining the
__comparable universe__and__controlling for differences__is far more difficult in practice than it is in theory.

- Defining the

**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.

- The variables used in defining the multiple

**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.**