Topic II. Valuation by Multiples

Question 1

What are some reasons for doing valuation by multiples?

Answer 1

• Quick, Convenient to calculate
• Use readily available data
• Simple, intuitive interpretations
• Easily-digestible

Question 2

What is the physical interpretation of a price-to-earnings (P/E) ratio?

Answer 2

It’s the amount you pay for $1.00 of earnings

Question 3

What is the physical interpretation of an

Enterprise Value / Total Asset ratio?

Answer 3

It’s the amount you paid much you pay for a $1.00 of assets - if you were an unlevered firm.

Question 4

What are the steps required to complete a valuation by multiples analysis?

Answer 4

1. Choose comparable firms
2. Choose bases for multiple
3. Choose: average/median across industries
4. Determine the base for the firm being valued
5. Value the firm (convert to price per share)

Question 5

What is the single most important step in the valuation by multiples analysis process?

Answer 5

1. Choosing comparable firms

Question 6

What is the formula for enterprise value?

Answer 6

Enterprise Value =MC +Total Debt− C

where:

MC=Market capitalization; equal to the current stockprice multiplied by the number of outstanding stock shares

Total debt=Equal to the sum of short-term andlong-term debt

C=Cash and cash equivalents; the liquid assets ofa company, but may not include marketable securities​

Question 7

True/False: The vast majority of corporate debt is traded.

Answer 7

False: The vast majority of corporate debt is not traded.

Question 8

How do we value a company’s debt?

Answer 8

we use the book value of a company’s debt

Question 9

A valuation multiple consists of a _________ and a _________.

Answer 9

A valuation multiple consists of a numerator and a denominator.

Question 10

What metrics can we use for the denominator?

Answer 10

Choose the denominator (base) from either:

• Balance Sheet
• Income Statement

Question 11

What does the left side of the balance sheet represent?

Balance Sheet

Total Assets | Total Debts

|

|

Shareholders Equity

Answer 11

The left side of the balance sheet represents enterprise value.

Question 12

What does the right side of the balance sheet represent?

Balance Sheet

Total Assets | Total Debts

|

|

Shareholders Equity

Answer 12

Those who have contributed funds to get that firm up and running.

Question 13

Draw the simplest form of an income statement

Answer 13

Question 15

Is the following an acceptible ratio?

[Enterprise Value]

[Total Assets]

Answer 15

Yes, because Enterprise Value and Total Assets both represent all shareholders.

Question 16

Is the following is an acceptible ratio?

[Enterprise Value]

[Stockholders Equity]

Answer 16

No!

EV represents ALL shareholders whereas, whereas stockholders equity only represents stockholders.

Question 17

Is the following is an acceptible ratio?

[Equity Value]

[Net Income]

Answer 17

Yes!

Because Equity Value represents stockholders and Net Income represents stockholders.

Question 18

What is the trick for knowing if an income statment metric represents all stakeholders (enterprise value) or just shareholders (equity value)?

Answer 18

Income Statement

+ REV

• COGS

- SGA

EBIT <———— EBIT and above is all stakeholders (Enterprise Value)

• Taxes <———– Amount attributible to governments

- Interest <———– Above line represents debt holders, shareholders

Net Income <———— Represents all shareholders (Equity Value)

Question 19

What are two acceptible Equity Value ratios?

Answer 19

[Market Value of Equity] / [Balance Sheet Shareholders Equity]

[Market Value of Equity] / [Net Income] == P/E

Question 20

What are four acceptible “Enterprise Ratio” metrics?

Answer 20

• EV / Total Assets
• EV / Revenue
• EV / EBITDA
• EV / EBIT

Question 21

What is, historically, the most accurate ratio?

Answer 21

Enterprise Value / Total Assets

Question 22

What is, historically, the least accurate ratio?

Answer 22

[Market Value] / [Net Income]

(P/E Ratio)

Question 23

What are the three ratios recommended by Craig Lewis?

Answer 23

1. Enterprise Value / Total Assets
2. Market Value of Equity / Book Value of Equity
3. Enterprise Value / EBITDA

Question 24

If given the following metrics, how would you calculate enterprise value?

• Average(EV/TA)
• TA

Answer 24

EV = Average(EV/TA) * TA

Question 25

How do you **select** _comparable_ **firms**?

Answer 25

​Go down the line and filter based on the following (starting from the top): 1. Industry Classification 2. Technology 3. Clientele 4. Size 5. Leverage 6. Profitibility

Question 26

**Explain** the **regression-based** approach to valuting by multiples?

Answer 26

1. Use every company in an industry 2. Choose metrics which are pertinent (EV/EBITDA, Revenue, Size) 3. Metrics become 'x' (independent) variables 4. Company value becomes 'y' (dependent) variable. 5. Calculate a linear regression equation. 6. Use 'company of interests' variables in the regression equation.

Question 27

What is the **MAIN IDEA** behind **valuation by multiples**?

Answer 27

“The basic idea behind using multiples for valuation is that **similar assets should sell for similar prices**, whether they are houses or shares of stock.”

Question 28

What is the issue of using **P/E ratio** as a **multiple**?

Answer 28

Although the P/E is widely used, it is **distorted by capital structure** and **nonoperating gains and losses**.

Question 29

When you are **building multiples**, the **denominator should be a** _\_\_\_\_\_\__(forecast, historical) **of profits**, preferably normalized for unusual items, rather than _\_\_\_\_\_\_\_\__ (forecasted, historical) profits.

Answer 29

When you are building multiples, the denominator should be a _forecast_ of profits, preferably normalized for unusual items, rather than _historical_ profits.

Question 30

Why are **forward-looking** metrics used when completing a **valuation by multiples**?

Answer 30

Forward-looking multiples generally have lower variation across peer companies.

Question 31

Why is **enterprise value to EBITA** preferrable to the **P/E ratio**?

Answer 31

Using net enterprise value to EBITA (or NOPAT) rather than a P/E **eliminates the distorting effect of different capital structures**”

Question 32

**Why** is **ROIC** preferred over return on assets (**ROA**)?

Answer 32

**ROIC is independent of operations structure**. ROA is a function of operations structure.

Question 33

**Why** is **ROIC** preferred over return on assets (**ROE**)?

Answer 33

**ROIC is independent of capital structure.** ROE is a function of capital structure.

Question 34

Which company would have **a lower P/E ratio** (all other things held equal)? **Company A**: 100% Equity Financed **Company B**: 80% Equity Financed, 20% Debt Financed

Answer 34

**Company B** because “P/E drops for the company with higher leverage”

Question 35

What is a **potential problem** with using the following **multiple**: ## Footnote **Enterprise-Value-to-EBITDA**

Answer 35

“Enterprise-Value-to-EBITDA Multiple **Distorted by Capital Investment**”

Question 36

“DiversCo, a large U.S. company, operates in two areas: energy and retail clothing. You observe an analyst report that values DiversCo using multiples analysis based on a peer group of other large U.S. diversified companies. Do you think that this is an appropriate approach? Why or why ”

Answer 36

This is not an appropriate approach. Valuations should be bottoms-up, not top-down. Diversified companies trade on the basis of the valuations of their individual businesses. Same thing should be done by Divers Co. It should be valued as the sum of its retail business and energy business. Also, some times a conglomerate discount is applied to Sum of the Parts valuation.

Question 37

Why should one use forward-looking multiples as opposed to backward-looking multiples when valuing companies?

Answer 37

This also avoids much of the ‘one-time item’ problem with actual reported earnings and ensures greater comparability of historical multiples to current and forward priced multiples if these are calculated using the same prospective earnings approach.

Question 38

What are the **limitations** of using **enterprise-value-to-revenues** multiples?

Answer 38

Ratio places emphasis on high revenue, which does not always correlate to cash flow.