When
comparing identical assets, we can compare the prices of these assets. Thus,
the price of a Tiffany lamp or a Mickey Mantle rookie card can be compared to
the price at which an identical item was bought or sold in the market. However,
comparing assets that are not exactly similar can be a challenge. If we have to
compare the prices of two buildings of different sizes in the same location, the
smaller building will look cheaper unless we control for the size difference by
computing the price per square foot. Things get even messier when comparing
publicly traded stocks across companies. After all, the price per share of a
stock is a function both of the value of the equity in a company and the number
of shares outstanding in the firm. Thus, a stock split that doubles the number
of units will approximately halve the stock price. To compare the values of
ÒsimilarÓ firms in the market, we need to standardize the values in some way by
scaling them to a common variable. In general, values can be standardized
relative to the earnings firms generate, to the book value or replacement value
of the firms themselves, to the revenues that firms generate or to measures
that are specific to firms in a sector.
One
of the more intuitive ways to think of the value of any asset is as a multiple
of the earnings that asset generates. When buying a stock, it is common to look
at the price paid as a multiple of the earnings per share generated by the
company. This price/earnings ratio can be estimated using current earnings per
share, yielding a current PE, earnings over the last 4 quarters, resulting in a
trailing PE, or an expected earnings per share in the next year, providing a
forward PE.
When
buying a business, as opposed to just the equity in the business, it is common
to examine the value of the firm as a multiple of the operating income or the
earnings before interest, taxes, depreciation and amortization (EBITDA). While,
as a buyer of the equity or the firm, a lower multiple is better than a higher
one, these multiples will be affected by the growth potential and risk of the
business being acquired.
While
financial markets provide one estimate of the value of a business, accountants
often provide a very different estimate of value of for the same business. The
accounting estimate of book value is determined by accounting rules and is
heavily influenced by the original price paid for assets and any accounting
adjustments (such as depreciation) made since. Investors often look at the
relationship between the price they pay for a stock and the book value of
equity (or net worth) as a measure of how over- or undervalued a stock is; the
price/book value ratio that emerges can vary widely across industries,
depending again upon the growth potential and the quality of the investments in
each. When valuing businesses, we estimate this ratio using the value of the
firm and the book value of all assets or capital (rather than just the equity).
For those who believe that book value is not a good measure of the true value
of the assets, an alternative is to use the replacement cost of the assets; the
ratio of the value of the firm to replacement cost is called TobinÕs Q.
Both
earnings and book value are accounting measures and are determined by
accounting rules and principles. An alternative approach, which is far less
affected by accounting choices, is to use the ratio of the value of a business
to the revenues it generates. For equity investors, this ratio is the
price/sales ratio (PS), where the market value of equity is
divided by the revenues generated by the firm. For firm value, this
ratio can be modified as the enterprise value/to sales ratio (VS), where the
numerator becomes the market value of the operating assets of the firm. This
ratio, again, varies widely across sectors, largely as a function of the profit
margins in each. The advantage of using revenue multiples, however, is that it
becomes far easier to compare firms in different markets, with different
accounting systems at work, than it is to compare earnings or book value
multiples.
While
earnings, book value and revenue multiples are multiples that can be computed
for firms in any sector and across the entire market, there are some multiples
that are specific to a sector. For instance, when internet
firms first appeared on the market in the later 1990s, they had negative
earnings and negligible revenues and book value. Analysts looking for a
multiple to value these firms divided the market value of each of these firms
by the number of hits generated by that firmÕs web site. Firms with lower
market value per customer hit were viewed as under valued. More recently, cable
companies have been judged by the market value per cable subscriber, regardless
of the longevity and the profitably of having these subscribers.
While
there are conditions under which sector-specific multiples can be justified,
they are dangerous for two reasons. First, since they cannot be computed for
other sectors or for the entire market, sector-specific multiples can result in
persistent over or under valuations of sectors relative to the rest of the
market. Thus, investors who would never consider paying 80 times revenues for a
firm might not have the same qualms about paying $2000 for every page hit (on
the web site), largely because they have no sense of what high, low or average
is on this measure. Second, it is far more difficult to relate sector specific
multiples to fundamentals, which is an essential ingredient to using multiples
well. For instance, does a visitor to a companyÕs web site translate into
higher revenues and profits? The answer will not only vary from company to
company, but will also be difficult to estimate looking forward.