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Unformatted text preview: Understanding Multiples Valuation
Chapter 13 Although DCF is derived from cash Although DCF is derived from cash flows and risk DCF gives no assurances that a buyer can be found at your calculated price It is supply and demand, and not mathematics in a vacuum, that sets security prices Because of this, we also use Comparable Company Analysis, or "Multiples Analysis", to value companies. We value securities relative to comparable companies. In General,
Value = Multiple * Valuation Metric The Key to Getting Valid Multiples is
The Key to Getting Valid Multiples is Having a numerator and denominator that are consistent with each other Valid Multiple = Value of Security divided by the Cash Flow (or Earnings) Available to That Security P/E multiples
P/E multiples P/E multiple, which has a consistent numerator and denominator, makes sense... Price/Earnings Ratio = Price per Share of Common Stock / Earnings per Share of Common Stock An equivalent P/E multiple
An equivalent P/E multiple Multiplying the numerator and denominator by shares outstanding gives an equivalent multiple:
Price/Earnings Ratio = Common Equity Value / Net Income Available to Common Price/Earnings Ratios Price/Earnings Ratios By multiplying a company's Earnings per Share (EPS) by the "appropriate" P/E multiple, one can determine the price of a share of that company's stock Share Price = P/E Ratio * Earnings per Share Analysts calculate P/E ratios for securities comparable to those of the client company. Assuming an average P/E of 10x Assuming an average P/E of 10x for the comparables, The analyst would conclude… "Since the comps trade at a price equal to $10 for every $1 of EPS, if my client has EPS of $2, my client's stock should be worth approximately $20." Mathematically, $2 * 10 = $20. Invalid Multiples
Invalid Multiples Invalid Multiple = Common Equity Value / EBITDA EBITDA does not represent cash flow available for equity holders since EBITDA is before payments to debt holders EBITDA is available to pay all debt and equity claims, so it is inappropriate to just have Equity Value in the numerator. The HOLY GRAIL!
EBITDA multiple! Enterprise Value / EBITDA Multiple
Enterprise Value / EBITDA Multiple Valid Multiple = (Common Equity Value + Net Debt + Preferred Stock) / EBITDA = Enterprise Value / EBITDA Enterprise Value = Multiple * EBITDA = Common Equity Value + Preferred + Debt – Cash Abstracted from DealMaven’s Knowledge Base
© 1999-2006 by DealMaven Inc.
http://www.dealmaven.com DCF EBITDA Multiples (A Proof)
• Suppose a business grows its cash flows at a constant rate in
Enterprise Value = C1/(r-g)
C1 = Next year’s Unlevered Free Cash Flow
r = Weighted Average Cost of Capital
g = Annual growth rate of cash flows • What is C?
UFCF = EBITDA – Cash Taxes on EBITA – Capex – Chg. Working Capital
UFCF = EBITDA * (1-T) * (1-R)
T = Adjusted Tax Rate; R = “Reinvestment Rate” (% of EBITDA reinvested in CAPEX and
Page 12 Abstracted from DealMaven’s Knowledge Base
© 1999-2006 by DealMaven Inc.
http://www.dealmaven.com DCF EBITDA Multiple Proof (Cont’d)
• So Enterprise Value can be expressed as:
EV = EBITDA0 * (1+g) * (1-T) * (1-R%)
r-g • Divide both sides by EBITDA:
EBITDA = (1+g) * (1-T) * (1-R%)
r-g Page 13 EV
(1 + g) (1 - T) (1 - R%)
WACC - g
Growth, risk, reinvestment rate, and tax rate
If two companies are similar across these four metrics, they should trade at similar multiples Higher growth businesses should be valued at higher multiples
Controlling for the industry and the company's competitive position Businesses with a high degree of Operating Risk should be valued at lower multiples Three sources of operating risk
Three sources of operating risk If customer demand (Revenue) is highly cyclical, Operating Risk is high. If Operating Leverage is high (i.e., the majority of costs are fixed), then Revenue fluctuations drop straight to the bottom line. This magnifies the impact of demand cyclicality and leads to high Operating Risk. If a company has low margins, then every dollar of profit swing is large in percentage terms. A low margin company has high Operating Risk – razor thin profit margins can easily swing into negative territory. So, firms with..
So, firms with.. Noncyclical demand (Revenue) and supply (costs) Low Operating Leverage High margins Should have higher EBITDA multiples Firms that reinvest a smaller % of EBITDA in CapEx and Working capital should be valued at higher multiples Firms with lower marginal tax rates should be valued at higher multiples
EBITDA multiple is decreasing in the marginal tax rate SUMMARY: The EV to EBITDA multiple should be higher if the firm has… A high projected growth rate Low Capital Expenditures and Working : Capital requirements relative to its EBITDA Noncyclical demand (Revenue) and supply (costs) Low Operating Leverage High margins A low tax rate Using the EBITDA Multiple to get Using the EBITDA Multiple to get stock price
EBI TDA Client
$20.00 ??? 10
$125.00 $50.00 0
40 First, calculate the Enterprise Value First, calculate the Enterprise Value of CompCo: Enterprise Value = Share Price * # Shares + Preferred + Debt – Cash Enterprise Value = $20.00 * 10.000 + $0.0 + $125.0 $25.0 = $300 Next, calculate the Enterprise Value Next, calculate the Enterprise Value / EBITDA multiple for CompCo: Multiple = Enterprise Value / EBITDA Multiple = $300 / 50 = 6.0x If ClientCo were valued at this If ClientCo were valued at this multiple, Then its Enterprise Value would be: Enterprise Value = Multiple * EBITDA Enterprise Value = 6.0x * $40.0 = $240.0 Then ClientCo’s Equity Value is
Then ClientCo’s Equity Value is Enterprise Value = Common Equity Value + Preferred + Debt – Cash Common Equity Value = Enterprise Value – Preferred – Debt + Cash Common Equity Value = $240.0 $25.0 $50.0 + $10.0 = $175.0 And ClientCo’s share price
And ClientCo’s share price Common Equity Value = Share Price * # Shares Share Price = Common Equity Value / # Shares Share Price = $175.0 / 17.500 = $10.00 ...
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