## Valuation multiples

In this blog, we shall look at how a properly executed analysis of valuation multiples can make the financial forecasting more accurate.

When valuing a company, not all valuation methods are considered equal.More managers gravitate towards DCF – Discounted Cash Flow analysis as they consider it as the most accurate method to value projects, divisions and businesses.

We know that an accurate valuation depends on the forecasting methods, hence errors in estimating ROIC – Return on Invested Capital, growth rate and Weighed average cost of Capital – WACC can lead to poor valuation which results in strategic errors.

### Importance of accurate analysis of Valuation multiples

- When estimating the growth rate and WACC, it is useful to compare the multiples of other companies, the market growth rate and historical data of the company. An proper execution of this analysis will help the company stress test its cash flow forecasts, identify any mismatch between its performance and competitors thereby coming to a decision whether it is strategically positioned to create more value than the other industry players.
- A multiple analysis can give insights to a company why its multiples are higher/lower than its peers.With this insights, the executives can identify the key factors contributing value in an industry.
- In reality, financial analysts apply multiples wrongly. For instance, they multiply an industry average P/E ratio with company’s earnings to establish a firm’s fair valuation. This is a flawed approach because even within the same industry, companies have different growth rates, returns on Invested capital and different capital structures.Even in companies with identical prospects, the P/E ratio can mislead as the net income includes both Operating and non-operating items.

### When and Why Valuation Multiples mislead?

- Many analysts report the stock performance of companies by creating a valuation table of the companies.The valuation summary is built by taking the closing day price of the company and its market capitalization.After this is done, the analysts project the firm’s future EPS.The forward looking P/E ratio of the companies is arrived by dividing stock price by its EPS.
- When the P/E ratio and EV/EBITDA is compared across companies within the same industry, there will high variations across the company. The reason for these huge variations is because investors have different expectations of how each company’s ability to create value.Hence the right companies for comparison should be selected based on similar expectations for growth and ROIC.
- The second big issues in multiples is that different multiples give conflicting results.For instance, one company might be trading at a premium using EV/EBITDA multiple but the same company will be trading at a discount using P/E ratios.This can happen because one company might have significant cash reserves which might inflate the P/E ratio artificially. This is because cash generates very little income.Hence in order to evaluate the multiples rightly, one should deduct the cash from the equity value and divide by post tax earnings.
- Many analysts have a wrong assumption that growth alone drives multiples.Growth increases P/E ratio only when combined with high ROIC.Hence investors need to focus on both growth and ROIC.

### How to apply valuation multiples properly?

Companies can apply the right multiples by using four basic principles.They are:

- Selecting peer companies with similar ROIC and growth prospects
- Using Forward Looking multiples
- Using Enterprise Value Multiples
- Adjusting EV/EBITDA multiple for non-operating items.

Let us dissect each principle seperately.

### Valuation multiples principle 1 – Selecting Peer companies with similar ROIC and growth prospects

- Finding the right set of companies for comparitive analysis is critical but challenging.Many analysts start by studying the industry but industries are very broad.Another way is to look at the competitors that company has listed in its annual report.
- Once we have the initial list of companies, the next step is to do a critical evaluation on the list.For example – Why are multiples different across the peer group? Is it because some companies have superior products, better access to customers, recurring revenues or have high economies of scale?
- If these strategic advantages is responsible for translating to higher ROIC and growth rates, then these companies should be trading at higher multiples compared to its peers.
- In order to do this analysis effectively, one should have deep knowledge of operating/financial specifics of each company, the products they sell, how they generate revenues and profits.

### Valuation multiples principle 2 -Use Forward Looking Multiples

- The principles of valuation, particularly the DCF model conveys that multiples should be estimated based on forecasted data rather than historical data.When forecasting is difficult and not reliable then historical data of latest fiscal year should be used and all one time events should be eliminated.
- This is because forward looking multiples are more accurate in predicting value and pricing.

### Valuation multiples principle 3 -Using Enterprise Value Multiples

- The P/E multiples have two major flaws.First they are affected by firm’s capital structure.For a company that does not have any debt component, the P/E ratio is high.Hence a company can artificially inflate its P/E ratio by swapping debt with equity.
- The other big flaw is that the P/E ratio also includes non-operating items like restructuring costs and write offs.Since the above charges are one time events, P/E multiples can be misleading. For instance, if a company writes off $100 billion of goodwill for an acquisition gone wrong and reports an EBITDA of $10 billion, the company still reports a post tax loss of $90 billion.In this case P/E multiples are invalid due to negative earnings.
- Hence a better alternative is to use EV/EBITDA multiple because this multiple is not affected by changes in capital structure.The only way this multiple can be impacted is when there is a change in the cost of capital.For instance, when a change in capital structure lowers the cost of capital, then the EBITDA multiples will increase.

### Valuation multiples principle 4 -Adjust EBITDA multiple for non-operating items

The EBITDA multiple is preferred over P/E multiple because it eliminates one time non operating items.The EBITDA multiple calculation also includes non-operating items that needs to be adjusted.These items include Operating leases and excess cash.Failing to adjust these items can generate misleading results.

Some common adjustments needed to be done are:

#### Excess cash and Non-operating assets

The EBITDA number might include excess cash generated from interest income.This should be adjusted and non operating assets needs to be evaluated separately.

#### Operating Leases

Companies that have significant operating leases will have low equity value because of debt component and low EBITDA value because rental expenses include interest costs.Although both affect the ratio in the same direction, they are not of the same magnitude.In order to estimate the right multiple, add the leased assets to market value of debt and equity.In addition, add the interest cost to EBITDA.

### Employee Stock Options

To determine the Enterprise value, calculate the present value of ESOP oustanding.As these ESOPS are not expensed, companies will report a high EBITDA number, hence adjust the ESOP grants from EBITDA.

### Pensions

The adjusted Enterprise value needs to be arrived by adding the present value of the pension liabilities. To eliminate the non-operating gains/losses, add the pension interest expenses with EBITDA, then deduct the returns on plan/assets and adjust for any accounting changes.

### Valuation Multiples for valuing startups

- For Valuing tech startups that report negative earnings, non financial multiples are of a better measure.These companies display high uncertainty surrounding their potential market size, profitability and investments they require.
- Non financial multiples compare enterprise value to non operating metric like website hits, unique visitors or the number of subscribers. These multiples are used only when they give better predictions than financial multiples.This is because when a company cannot translate website hits and visitors into profits and cashflow, using the non financial multiple is useless.

## Conclusion

Even though the Discounted Cash Flow model is the most reliable valuationÂ method available, the accuracy of the DCF model relies on the thoughtful and correct analysis of valuation multiples.