PPT on Financial Modelling.. valuation techniques...finance models...

1. Chapter 14
Using Multiples to Triangulate Results
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2. Why Use Multiples?
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.
• 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.
2

3. 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
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$ million Debt and Gross Net
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.
1-year forward multiples (times)

4. 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

5. Enterprise Value to EBITA
g
(1 T) 1
Value ROIC
EBITA WACC g
 
 
 
 


g
g









WACC
ROIC
1
NOPLAT
Value
g
EBITA(1-T) 1
ROIC
Value
WACC g
 

 
 


Substitute EBITA(1 − T)
for NOPLAT.
Start with the key value
driver formula.
Divide both sides by EBITA
to develop the enterprise
value multiple.
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:
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6. Enterprise Value to EBITA
g
g
T










WACC
ROIC
1
)
(1
EBIT
Value
• 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?
7
.
11
%
5
%
9
15%
5%
1
)
30
.
(1
EBIT
Value











6

7. 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.
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Number of observations
1
Excluding financial institutions, real estate companies, and companies with extremely small or
negative EBITA.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Enterprise value to EBITA
S&P 5001: Distribution of Enterprise Value to EBITA, December 2009

8. 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:
EBITA
Equity
MV
Debt
MV
EBITA
Value
Enterprise 

• 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.
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9. 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.
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P/E Multiple Distorted by Capital Structure
Since Companies A and
B trade at low enterprise
value multiples, the
price-to-earnings ratio
drops for the company
with higher leverage.
Since Companies C and
D trade at high
enterprise value
multiples, the price-to-
earnings ratio increases
for the company with
higher leverage.
$ million
Income statement Company A Company B Company C Company D
EBITA 100 100 100 100
Interest expense − (20) − (25)
Earnings before taxes 100 80 100 75
Taxes (40) (32) (40) (30)
Net income 60 48 60 45
Market values
Debt − 400 − 500
Equity 1,000 600 2,500 2,000
Enterprise value (EV) 1,000 1,000 2,500 2,500
Multiples (times)
EV to EBITA 10.0 10.0 25.0 25.0
Price to earnings 16.7 12.5 41.7 44.4

10. Why EBITA and Not EBITDA?
10
• Consider three companies, named A,
B, and C. Each company generates the
same level of underlying operating
profitability; they differ only in size.
• Since all three companies generate the
same level of operating performance,
they trade at identical multiples before
the acquisition of B by A.
• Following the acquisition, however,
amortization expense causes EBIT to
drop for the combined company and
the enterprise value-to-EBIT multiple to
rise.
Enterprise-Value-to-EBIT Multiple
Distorted by Acquisition Accounting
$ million
EBIT Company A Company B Company C Company A+B Company C
Revenues 375 125 500 500 500
Cost of sales (150) (50) (200) (200) (200)
Depreciation (75) (25) (100) (100) (100)
Amortization − − − (25) −
EBIT 150 50 200 175 200
Invested capital
Organic capital 750 250 1,000 1,000 1,000
Acquired intangibles − − − 125 −
Invested capital 750 250 1,000 1,125 1,000
Enterprise value 1,125 375 1,500 1,500 1,500
Multiples (times)
EV to EBITA 5.0 5.0 5.0 5.0 5.0
EV to EBIT 7.5 7.5 7.5 8.6 7.5
After A acquires B
Before acquisition

11. Why EBITA and Not EBITDA?
Company B outsources
manufacturing to another
company.
Incurs depreciation cost
indirectly through an
increase in the cost of
raw material.
Company A
manufactures
products with its
own equipment.
Incurs depreciation
cost directly.
• 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 ($3,000).
• What is each companies EV-to-EBITDA multiple and why are they different?
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$ million
Income statement Company A Company B
Revenues 1,000 1,000
Raw materials (100) (250)
Operating costs (400) (400)
EBITDA 500 350
Depreciation (200) (50)
EBITA 300 300
Operating taxes (90) (90)
NOPLAT 210 210

12. 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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13. 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.
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Pharmaceuticals: Backward- and Forward-Looking Multiples, December 2007
Whereas historical
P/E ratios across
pharmaceutical
companies show
significant variation…
Price/earnings Enterprise value/EBITA
2007 net income Estimated 2008 EBITA
1
Estimated 2012 EBITA
1
38
27
24
20
20
19
18
16
14
13
12
Merck
Bristol-Myers Squibb
Abbott
Eli Lilly
Novartis
Pfizer
Johnson & Johnson
Sanofi-Aventis
GlaxoSmithKline
Wyeth
AstraZeneca
Schering-Plough N/A2
16
17
16
13
17
13
15
13
15
12
15
16
12
12
12
12
13
13
12
12
12
12
12
11
the forward-looking
EV-to-EBITA
multiples are nearly
identical.
1Consensus analyst forecast.
2Schering-Plough recorded loss in 2007, so no multiple is reported.

14. 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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15. 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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16. Consistency: Nonoperating Assets
• Company A holds only core operating
assets and is financed by traditional
debt and equity.
• Company B operates a similar
business to Company A, but it also
owns $100 million in excess cash and
a minority stake in a nonconsolidated
subsidiary, valued at $200 million.
• Since excess cash and
nonconsolidated subsidiaries do not
contribute to EBITA, they should not
be included in the numerator of an
EV-to-EBITA multiple.
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Enterprise Value Multiples and Complex Ownership
Partial income statement
Company A Company B
EBITA 100 100
Interest income − 4
Interest expense (18) (18)
Earnings before taxes 82 86
Gross enterprise value
Value of core operations 900 900
Excess cash − 100
Nonconsolidated subsidiaries − 200
Gross enterprise value 900 1,200
Debt 300 300
Minority interest − −
Market value of equity 600 900
Gross enterprise value 900 1,200

17. Consistency: Include All Financial Claims
• For Company C, outside investors hold
a minority stake in a consolidated
subsidiary.
• Since the minority stake’s value is
supported by EBITA, it must be included
in the enterprise value calculation.
Otherwise, the EV-to-EBITA multiple will
be biased downward.
• The numerator should include not just
debt and equity, but also minority
interest, the value of unfunded pension
liabilities, and the value of employee
grants outstanding.
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Enterprise Value Multiples and Complex Ownership
Partial income statement
Company A Company C
EBITA 100 100
Interest income − −
Interest expense (18) (18)
Earnings before taxes 82 82
Gross enterprise value
Value of core operations 900 900
Excess cash − −
Nonconsolidated subsidiaries − −
Gross enterprise value 900 900
Debt 300 300
Minority interest − 100
Market value of equity 600 500
Gross enterprise value 900 900

18. 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.
Interest
Lease
Implied
EBITA
Equity
Leases)
ng
PV(Operati
Debt
EBITA
Value
Enterprise




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 - ServiceCost
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19. 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

20. 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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21. 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.
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g
(1 T) 1
Value ROIC
EBITA WACC g
 
 
 
 


Peers in the same industry
will have similar risk profiles
and consequently similar
costs of capital.
Since growth will vary
across companies, so
will their enterprise
value multiples.
Be careful comparing across
countries. Different tax rates
will drive differences in
multiples.
Companies with higher
ROICs will need less
capital to grow. This will
drive higher multiples.

22. 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×.
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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
Low growth,
low margin
Low growth,
high margin
High growth,
high margin
7
7
9
9
11
13
Company A
Company B
Company C
Company D
Company E
Company F
5
3
4
3
7
8
12
6
21
24
18
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23. 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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