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Using Multiples to Triangulate Results

1
 Why Use Multiples?
• A careful multiples analysis—comparing a company’s multiples versus those
of comparable companies—can be useful in improving cash flow forecasts
and testing the credibility of DCF-based valuations.

Multiples can assist in:

1. Testing the plausibility of forecasted cash flows.
2. Identifying disparities between a company’s
performance and those of its competitors.
3. Identifying which companies the market
believes are strategically positioned to create
more value than other industry players.

Multiples analysis is useful only when performed accurately. Poorly

performed multiples analysis can lead to misleading conclusions.

2
 What Are Multiples?
• Multiples such as the enterprise-value-to-revenue ratio and the enterprise-value-to-
EBITA ratio are used to compare the relative valuations of companies. Multiples
normalize market values by revenues, profits, asset values, or nonfinancial statistics.

Specialty Retail: Trading Multiples, December 2009

$ million Debt and Gross Net 1-year forward multiples(times)

Market debt enterprise enterprise
Ticker Company capitalization equivalents value value Revenue EBITDA EBITA
AZO AutoZone 7,915 2,783 10,698 10,535 1.5 7.5 8.5
BBBY Bed Bath & Beyond 10,368 − 10,368 9,477 1.3 9.5 11.3
BBY Best Buy 16,953 2,476 19,429 18,525 0.4 6.0 7.4
HD Home Depot 49,601 11,434 61,035 60,510 0.9 9.2 13.0
LOW Lowe's 34,814 6,060 40,874 39,960 0.8 8.3 12.2
PETM Petsmart 3,386 634 4,019 3,867 0.7 6.5 10.4
SHW Sherwin-Williams 7,029 1,099 8,128 8,044 1.1 9.5 11.4
SPLS Staples 18,054 3,518 21,572 20,938 0.9 10.1 13.2

Mean 1.0 8.3 10.9

Median 0.9 8.8 11.4
Deviation (percent)1 38.1% 17.3% 18.2%

1
Deviation = Standard deviation/median.

3
 Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:
1. Use the right multiple. For most analyses, enterprise value to EBITA is the
best multiple for comparing valuations across companies. Although the price-to-
earnings (P/E) ratio is widely used, it is distorted by capital structure and
nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you
exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.
Refine the sample to peers that have similar outlooks for long-term growth and
return on invested capital (ROIC).

4
 Enterprise Value to EBITA

When computing and comparing industry multiples, always start with

enterprise value to EBITA. It tells more about a company’s value than
any other multiple. To see why, consider the key value driver formula
developed earlier:
 g 
NOPLAT 1  
 ROIC 
Start with the key value Value 
WACC  g
driver formula.

 g 
EBITA(1-T) 1  
Substitute EBITA(1 − T) Value   ROIC 
for NOPLAT. WACC  g

Divide both sides by EBITA  g 

(1  T) 1  
Value  ROIC 
to develop the enterprise 
EBITA WACC  g
value multiple.

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 Enterprise Value to EBITA
• Let’s use the formula to predict the enterprise-value-to-EBITA multiple for a
company with the following financial characteristics:
• Consider a company growing at 5 percent per year and generating a 15
percent return on invested capital. If the company has an operating tax rate
at 30 percent and a 9 percent cost of capital, what multiple of EBITA should
it trade at?
 g 
(1  T )1  
Value  ROIC 

EBIT WACC  g

 5% 
(1  .30)1  
Value  15% 
  11 .7
EBIT 9%  5%

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 Distribution of EV to EBITA

• The majority of companies fall between 7 times and 11 times

EBITA. If the company or industry you are examining falls outside
this range, make sure to identify the reason.
S&P 5001: Distribution of Enterprise Value to EBITA, December 2009

Number of observations

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Enterprise value to EBITA

1
Excluding financial institutions, real estate companies, and companies with extremely small or
negative EBITA.

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 Why EV to EBITA and Not Price to Earnings?
• A cross-company multiples analysis should highlight differences in performance, such
as differences in ROIC and growth, not differences in capital structure.
• Although no multiple is completely independent of capital structure, an enterprise value
multiple is less susceptible to distortions caused by the company’s debt-to-equity
choice. The multiple is calculated as follows:

Enterprise Value MV Debt  MV Equity


EBITA EBITA

• Consider a company that swaps debt for equity (i.e., raises debt to repurchase equity).
• EBITA is computed pre-interest, so it remains unchanged as debt is swapped
for equity.
• Swapping debt for equity will keep the numerator unchanged as well. Note,
however, that EV may change due to the second-order effects of signaling,
increased tax shields, or higher distress costs.

8
 Why EV to EBITA and Not Price to Earnings?
• To show how capital structure distorts the P/E, consider four companies, named A
through D. Companies A and B trade at 10 times enterprise value to EBITA, and
Companies C and D trade at 25 times enterprise value to EBITA.

P/E Multiple Distorted by Capital Structure

$ million

Income statement Company A Company B Company C Company D

EBITA 100 100 100 100
Since Companies A and Interest expense − (20) − (25) Since Companies C and
Earnings before taxes 100 80 100 75
B trade at low enterprise D trade at high
Taxes (40) (32) (40) (30)
value multiples, the Net income 60 48 60 45 enterprise value
price-to-earnings ratio Market values multiples, the price-to-
Debt − 400 − 500
drops for the company Equity 1,000 600 2,500 2,000
earnings ratio increases
with higher leverage. Enterprise value (EV) 1,000 1,000 2,500 2,500
for the company with
Multiples (times) higher leverage.
EV to EBITA 10.0 10.0 25.0 25.0
Price to earnings 16.7 12.5 41.7 44.4

9
 Why EBITA and Not EBITDA?

• Consider three companies, named A, Enterprise-Value-to-EBIT Multiple

Distorted by Acquisition Accounting
B, and C. Each company generates the
same level of underlying operating $ million
Before acquisition After A acquires B

profitability; they differ only in size. EBIT Company A Company B Company C Company A+B Company C
Revenues 375 125 500 500 500
• Since all three companies generate the Cost of sales (150) (50) (200) (200) (200)
Depreciation (75) (25) (100) (100) (100)
same level of operating performance, Amortization
EBIT
−
150
−
50
−
200
(25)
175
−
200

they trade at identical multiples before Invested capital

the acquisition of B by A. Organic capital

Acquired intangibles
750
−
250
−
1,000
−
1,000
125
1,000
−
Invested capital 750 250 1,000 1,125 1,000
• Following the acquisition, however,
Enterprise value 1,125 375 1,500 1,500 1,500
amortization expense causes EBIT to
Multiples (times)
drop for the combined company and EV to EBITA
EV to EBIT
5.0
7.5
5.0
7.5
5.0
7.5
5.0
8.6
5.0
7.5
the enterprise value-to-EBIT multiple to
rise.

10
 Why EBITA and Not EBITDA?
• Many financial analysts use multiples of EBITDA, rather than EBITA, because
depreciation is a noncash expense, reflecting sunk costs, not future investment.
• But EBITDA multiples have their own drawbacks. To see this, consider two companies,
which differ only in outsourcing policies. Because they produce identical products at
the same costs, their valuations are identical ($3,000).
• What is each companies EV-to-EBITDA multiple and why are they different?

$ million

Income statement Company A Company B Company B outsources

Company A Revenues 1,000 1,000
manufacturing to another
manufactures Raw materials (100) (250)
company.
products with its Operating costs (400) (400)
EBITDA 500 350
own equipment.
Incurs depreciation cost
Depreciation (200) (50) indirectly through an
Incurs depreciation
EBITA 300 300 increase in the cost of
cost directly.
raw material.
Operating taxes (90) (90)
NOPLAT 210 210

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 Use Forward-Looking Multiples

• When building multiples, the denominator should use a forecast of

profits, rather than historical profits.
– Unlike backward-looking multiples, forward-looking multiples are
consistent with the principles of valuation—in particular, that a
company’s value equals the present value of future cash flows,
not sunk costs.
– Second, forward-looking earnings are typically normalized,
meaning they better reflect long-term cash flows by avoiding
one-time past charges.

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 Use Forward-Looking Multiples
• To build a forward-looking multiple, choose a forecast year for EBITA that best represents
the long-term prospects of the business.
• In periods of stable growth and profitability, next year’s estimate will suffice. For
companies generating extraordinary earnings (either too high or too low) or for
companies whose performance is expected to change, use projections further out.
Pharmaceuticals: Backward- and Forward-Looking Multiples, December 2007

Price/earnings Enterprise value/EBITA

2007 net income Estimated 2008 EBITA1 Estimated 2012 EBITA1

Merck 38 16 12
Bristol- Myers Squibb 27 17 12
Whereas historical Abbott 24 16 12
the forward-looking
P/E ratios across Eli Lilly 20 13 12
Novartis 20 17 13
EV-to-EBITA
pharmaceutical
Pfizer 19 13 13 multiples are nearly
companies show Johnson & Johnson 18 15 12 identical.
significant variation… Sanofi-Aventis 16 13 12
GlaxoSmithKline 14 15 12
Wyeth 13 12 12
AstraZeneca 12 15 12
Schering-Plough N/A2 16 11
1
Consensus analyst forecast.
2
Schering-Plough recorded loss in 2007, so no multiple is reported.

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 Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:
1. Use the right multiple. For most analyses, enterprise value to EBITA is the
best multiple for comparing valuations across companies. Although the price-to-
earnings (P/E) ratio is widely used, it is distorted by capital structure and
nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you
exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.
Refine the sample to peers that have similar outlooks for long-term growth and
return on invested capital (ROIC).

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Calculate the Multiple in a Consistent Manner
• There is only one approach to building an enterprise-value-to-EBITA
multiple that is theoretically consistent. Enterprise value must include all
investor capital but only the portion of value attributable to assets that
generate EBITA.

• Including value in the numerator without including its corresponding income

in the denominator will systematically distort the multiple upward.

• Conversely, failing to recognize a source of investor capital, such as

minority interest, will understate the numerator, biasing the multiple
downward. If the company holds nonoperating assets or has claims on
enterprise value other than debt and equity, these must be accounted for.

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 Consistency: Nonoperating Assets

• Company A holds only core operating

Enterprise Value Multiples and Complex Ownership
assets and is financed by traditional Company A Company B
debt and equity. Partial income statement
EBITA 100 100
• Company B operates a similar Interest income − 4
Interest expense (18) (18)
business to Company A, but it also Earnings before taxes 82 86
owns $100 million in excess cash and
a minority stake in a nonconsolidated Gross enterprise value
Value of core operations 900 900
subsidiary, valued at $200 million.
Excess cash − 100
• Since excess cash and Nonconsolidated subsidiaries − 200
Gross enterprise value 900 1,200
nonconsolidated subsidiaries do not
contribute to EBITA, they should not Debt 300 300
Minority interest − −
be included in the numerator of an Market value of equity 600 900
EV-to-EBITA multiple. Gross enterprise value 900 1,200

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 Consistency: Include All Financial Claims

Enterprise Value Multiples and Complex Ownership

• For Company C, outside investors hold
a minority stake in a consolidated Company A Company C
Partial income statement
subsidiary. EBITA 100 100
Interest income − −
• Since the minority stake’s value is Interest expense (18) (18)
supported by EBITA, it must be included Earnings before taxes 82 82

in the enterprise value calculation.

Gross enterprise value
Otherwise, the EV-to-EBITA multiple will
Value of core operations 900 900
be biased downward. Excess cash − −
Nonconsolidated subsidiaries − −
• The numerator should include not just Gross enterprise value 900 900
debt and equity, but also minority
Debt 300 300
interest, the value of unfunded pension Minority interest − 100
liabilities, and the value of employee Market value of equity 600 500
Gross enterprise value 900 900
grants outstanding.

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 Advanced Adjustments
For companies with rental expense or pension assets, two additional
adjustments can be made.
1. The use of operating leases leads to artificially low enterprise value (missing debt)
and EBITA (lease interest is subtracted pre-EBITA). Although operating leases affect
both the numerator and denominator in the same direction, each adjustment is of a
different magnitude.

Enterprise Value Debt  PV(Operating Leases)  Equity


EBITA EBITA  Implied Lease Interest

2. To adjust enterprise value for pensions, add the present value of unfunded pension
liabilities to debt plus equity. To remove gains and losses related to plan assets, start
with EBITA, add back pension expense, and deduct any service costs.

Enterprise Value Debt + PV(Unfunded Pensions) + Equity

=
EBITA EBITA + Pension Expense - Service Cost

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 Session Overview

• During this session, we will use three guidelines to build a careful

multiples analysis:
1. Use the right multiple. For most analyses, enterprise value to EBITA is the
best multiple for comparing valuations across companies. Although the price-to-
earnings (P/E) ratio is widely used, it is distorted by capital structure and
nonoperating gains and losses.

2. Calculate the multiple in a consistent manner. Base the numerator (value)

and denominator (earnings) on the same underlying assets. For instance, if you
exclude excess cash from value, exclude interest income from the earnings.

3. Use the right peer group. A set of industry peers is a good place to start.
Refine the sample to peers that have similar outlooks for long-term growth and
return on invested capital (ROIC).

19
 Selecting a Robust Peer Group

To create and analyze an appropriate peer group:

• Start by examining other companies in the target’s industry. But how do you
define an industry?
• Potential resources include the annual report, the company’s Standard
Industry Classification (SIC), or its Global Industry Classification (GIC).
• Once a preliminary screen is conducted, the real digging begins. You must
answer a series of strategic questions.
• Why are the multiples different across the peer group?
• Do certain companies in the group have superior products, better
access to customers, recurring revenues, or economies of scale?

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 Expect Variation Even within an Industry

• As demonstrated earlier, the enterprise-value-to-EBITA multiple is

driven by growth, ROIC, the operating tax rate, and the company’s
cost of capital.

Be careful comparing across Companies with higher

countries. Different tax rates ROICs will need less
will drive differences in capital to grow. This will
multiples. drive higher multiples.
 g 
(1  T) 1  
Value  ROIC 

EBITA WACC  g

Peers in the same industry Since growth will vary

will have similar risk profiles across companies, so
and consequently similar will their enterprise
costs of capital. value multiples.

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 ROIC and Growth Drive Variation
• The companies below fall into three performance buckets that align with different
multiples. The companies with the lowest margins and low growth expectations had
multiples of 7×. The companies with low growth but high margins had multiples of 9×.
Finally, the companies with high growth and high margins had multiples of 11× to 13×.

Factors for Choosing a Peer Group

Valuation multiples Consensus projected financial performance

Enterprise value/ Sales growth, EBITA margin,

EBITA 2010–2013 2010 Performance
(percent) (percent) characteristics

Company A 7 5 12 Low growth,

Company B 7 3 low margin
6
Company C 9 4 21 Low growth,
Company D 9 3 24 high margin
Company E 11 7 18
High growth,
Company F 13 8 24 high margin

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 Closing Thoughts

A multiples analysis that is careful and well reasoned not only will provide a useful check of
your discounted cash flow (DCF) forecasts but also will provide critical insights into what
drives value in a given industry. A few closing thoughts about multiples:
1. Similar to DCF, enterprise value multiples are driven by the key value drivers, return
on invested capital and growth. A company with good prospects for profitability and
growth should trade at a higher multiple than its peers.
2. A well-designed multiples analysis will focus on operations, will use forecasted
profits (versus historical profits), and will concentrate on a peer group with similar
prospects.
• P/E ratios are problematic, as they commingle operating, nonoperating, and
financing activities, which leads to misused and misapplied multiples.
3. In limited situations, alternative multiples can provide useful insights. Common
alternatives include the price-to-sales ratio, the adjusted price-earnings growth
(PEG) ratio, and multiples based on nonfinancial (operational) data.

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