How do you use multiples in valuation? Valuation using Multiples.

In this article, we're going to talk about how to value a firm using multiples. So previously we talked about the dividend discount model and how we can view the firm as a stream of dividends that we can discount back to the present. We also talked about the total payout model, where we see we're going to focus on dividends and share repurchases all distributions to equity holders. Now we say "Well, look we can actually not even look at dividends not even look at share repurchases and just focus on free cash flow, we can just use discounted free cash flow model and that's not even effective by firms borrowing choices and so forth, but all of these three methods here have in common that in some way they're dependent on the firm's future cash flows, whether it be dividends, repurchases or free cash flow they're all basically some form of cash flow that we're trying to discount back to the present.


So for certain firms there might be an issue where maybe we have a hard time estimating cash flows or maybe we just want something a little bit easier than using these three methods and what we can do is we can use multiples, for example, the price to earnings ratio and we could take a comparable firm, and we're trying to value firm one and we say firm two is comparable in the sense that it has an identical value maybe it's a and identical type of firm they operate in the same industry if we know the value of this comparable firm and it's identical then we can say we know the value of the other firm even though we didn't have a price, we can impute the price or the value from the comparable firm to the price of the firm that we're trying to value.


Let's say you've got whiz-bang technologies they're going public so because they're not publicly traded yet we don't have like a stock price or something that we look at, we're trying to estimate that we want to estimate whiz bangs value. So that we know what's a good price to pay for it. All we know right now is whiz bangs earnings per share is $1.57. All right so they're earning $1.57 a share but the great thing is that we've got this "Humdrum Industry" this is going to be our comparable firm. We say this humdrum industry has a lot in common with whiz-bang and so we can use them as a comparable firm as a benchmark to estimate the price for whiz-bang.


We also do know the share price of humdrum it's $30.94 a share and we also know their earnings and their earnings per share is $2.38 a share. Now we can calculate their price to earnings ratio. It's going to be the $30.94 divided by $2.38 and that's going to give us 13. So that's our price-to-earnings ratio for humdrum. 


Now let's come up to whiz-bang, with whiz-bang if the same price-to-earnings ratio. Well, we don't know whiz bangs price, we don't know that part so we'll leave that blank for right now but we do know the denominator, we do know earnings. So we've got this $1.57 in the denominator. So we know that this price-earnings ratio assuming that this is a valid comparable firm this humdrum industry we can just plug in this 13 for whiz bang's P/E ratio. Now just think of this as algebra, we've got 13 is equal to some blank number here which is our share price and in the denominator, we have $1.57. 


What do we do we just multiply each side by $1.57. So we take this ($1.57 X 13) equals $20.41 which is our share price. All we did is we take the multiple that we got from humdrum. Humdrum gave us this multiple of 13 so the price to earnings ratio should be 13. Basically, think of it like this price-earnings ratio basically a dollar of earnings is being valued at $13 in this particular industry. So we'll just multiply that by the price to earnings multiple of 13 and that gives us this $20.41 a share so that's with bangs price.

Now there are some problems with this method, That we haven't taken into consideration any growth options whiz-bang might have a lot more growth options than humdrum. Maybe humdrum has been in the industry a long time they don't really have a lot of great projects on the horizon but whiz-bang they've got some new patents or technology and they're gonna have a lot more growth than humdrum industries. It might actually be that the better P/E ratio for whiz-bang which is something higher than 13, maybe investors willing to pay $19 per dollar of earnings for whiz being because of those growth options. 

Also, the firm's might have different leverage, when we did free cash flow we're basically factoring out firms borrowing decisions but here we're not doing any of that at all. These firms might have a lot of different leverage and just looking at this multiple isn't going to necessarily tell us anything. Now what we could do? We could look at the enterprise value multiple instead of the P/E ratio and in that case, we're factoring in firms borrowing and leveraged decisions.


So we might have to use a different type of multiple if there's a lot of differences in leverage between the two firms and a really important factor is as well is that it's really difficult to look at two different firms and assume that they have the exact same risk just because they operate in a similar industry or so forth. They might have very very different risks and we're not taking that into consideration whether we use the EV multiple or the Price Earnings multiples there's really something difficult to control for and when we use these multiple valuations we're not really capturing any differences in risk.

You might be wondering why is anybody use multiple valuation? Why are we using P/E ratios or EV multiples to value firms? Why are we doing any of this? Well, one thing to notice is it's based on actual prices, so when we look at humdrum industries we're actually looking at their share price we're benchmarking and using an actual share price, to count the share price for whiz-bang in a matter of fact, we don't just have to use just one firm as the competitor we could have lot's of comparable firms depends on how many firms we think are comparable and we could take the average P/E ratio of all the comparable firms and then use that instead of this 13. 


So we're using actual share prices that the investors are paying and so forth for these other firms to benchmark and come up with a price instead of just saying oh we've got some pie-in-the-sky dividends or something that we think are going to happen for whiz-bang at some point in the future. Probably the reason that most people like multiple valuation or using comparable firms is the ease of use, it's just really easy to just say you know what this firm over here they've got a P/E ratio of 13 and this firm is very similar, so we think that we'll just multiply it by the P/E ratio and that gives us a rough idea of what that firm should be.

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