WHAT ARE MULTIPLES?
Multiples refer to financial metrics where one aspect is compared as a ratio of another aspect in the form of ratios to be able to compare different companies on a similar ground. These are like measuring sticks used to figure out how much a company might be worth compared to how well it’s doing in a certain area. It’s like using a comparison to understand if a company is valued fairly based on things like its earnings, sales, or other important numbers related to how it runs.
When we talk about valuation multiples (like price-to-earnings ratio or price-to-sales ratio), it means using certain numbers to figure out how much a company might be worth.
But here’s the thing: these numbers only make sense if we really know a lot about the company we’re looking at. We need to understand things like what the company does, how it competes with other similar companies, what’s going on in the industry it’s part of, and what factors are really important for that particular kind of business.
So, to use these valuation numbers properly, we have to really understand the company and the industry it’s in. Without that understanding, these numbers might not give us an accurate picture of how valuable the company truly is.
2 types of valuation multiples are:
- Equity multiples
- Enterprise Value multiples
Let’s discuss each one of them separately.
Equity Multiples
Whenever someone wants to acquire a small stake in a company and wants to decide whether to invest in a particular company or not, Equity Multiples can be used. Some of the most prominent ones have been mentioned individually below.
Share Price/Sales
The Company’s Share Price is divided by Total Sales. Kenneth L. Fisher, a stock market expert, noticed that investors often get overly optimistic about a growing company’s worth. When these companies don’t meet these high expectations, investors tend to panic and sell their stock. Fisher believed that well-managed companies could identify and fix issues, leading to an increase in their stock price and earnings.
Price to Sales = Share Price / Total Price
To address the issue of exaggerated valuations, Fisher created the Price to Sales(P/S) ratio. This ratio uses a company’s sales value in its formula because sales tend to be more stable than earnings, which can fluctuate. Sales are less affected by accounting methods, providing a more consistent measure for evaluation.
Price to Sales = Share Price / Total Sales
The Share Price/Total Sales ratio is a simple way to figure out how much investors are paying for a company. It shows this by comparing the company’s market value (the price) to its sales.
Basically, a company’s main job is to make money by selling stuff or providing services. The P/S ratio looks at how investors value the company based on this without getting into complicated financial details.
For new companies that don’t yet make a profit, the P/S ratio helps them figure out how much their stuff is worth. A low P/S ratio usually means the company might be a good deal because it’s undervalued. But remember, it’s important to check this ratio compared to how the company did before and how other similar companies are doing.
So, the Share Price/Sales ratio is a quick and easy way to see if a company’s stock might be a good buy, but it’s not the only thing to consider. You need to look at other factors too!
Share Price/Book Value of Assets
Here company’s Per share price is divided by the Book Value of Assets Per Share and is majorly done in cases when the main drivers of the company are its assets.
Price-to-Book = Share Price/ Book Value of Assets
The Price-to-Book (P/B) ratio is a way to compare a company’s market value with the value of its assets. It helps investors understand if a company’s stock is priced fairly compared to what the company owns.
Imagine you want to figure out if a company’s stocks are a good deal. The P/B ratio helps with this. It looks at how much the company is worth on the stock market (market capitalization) compared to what it actually owns (book value of its assets).
Price-to-Book = Share Price / Book Value of Assets
To calculate this ratio:
1. Find the market capitalization by multiplying the current stock price by the total number of outstanding shares.
2. Calculate the book value of assets by adding up all the values of the company’s assets listed on its balance sheet and subtracting all debts and liabilities.
3. Divide both market capitalization and book value of assets by the number of outstanding shares to get the Market Price Per Share and Book Value of Assets Per Share respectively.
4. Finally, divide the Market Price Per Share and Book Value of Assets Per Share to calculate the Share Price/Book Value of Assets Ratio
Value investors like using the P/B ratio to see if a company’s stock might be a good buy. They look for stocks that seem cheaper than they should be based on what the company owns. This ratio helps them decide if the stocks are undervalued (a possible good buy) or overvalued (might not be a good deal).
So, the P/B ratio gives insight into whether a company’s stock is priced right compared to what the company actually owns.
P/E Ratio
This is the most popular ratio in the world of valuations where Per Share Price is divided by EPS i.e. Earning Per Share.
EPS stands for Earnings Per Share. It tells you how much profit a company has made for each share of its stock. To calculate EPS, you take the earnings a company made in the last twelve months and divide that by the average number of shares it has.
Price to Earnings = Share Price / Earning Per Share
Earnings are the profits a company makes, but sometimes there might be unusual or one-time things that can make the earnings seem higher or lower than usual. So, to get a clearer picture, companies might adjust the earnings to take out these unusual things before calculating EPS. This helps to show a more normal level of earnings that investors can use to evaluate the company’s performance.
Price to Earnings = Share Price / Earning Per Share
Another variation of the Price to Earnings Ratio is Market Capitalization / Total Net Earnings.
Price to Earnings = Market Capitalization/ Total Net Earnings
There is another angle to it i.e. Justified P/E Ratio which is the Dividend Payout Ratio / R – G where R is the Required Rate of Return and G is the Sustainable Growth Rate.
Price to Earnings = Market Capitalization / Total Net Earnings
The justified P/E ratio helps investors figure out the right price they should pay for a stock. It considers things like how much a company pays in dividends, how fast the company is growing, and how much return an investor wants.
When investors compare the justified P/E ratio to the basic P/E ratio, it helps them decide if a stock is overpriced, underpriced, or priced fairly. This comparison is a common way to evaluate stocks and decide if they’re worth investing in.
Imagine you’re looking at companies as if they were giant treasure chests. When a company has a high Price Earnings Ratio (P/E Ratio), it’s like saying people believe there’s a lot of treasure inside and that the company will make a lot more money in the future. This gets investors excited, so they’re willing to pay more to own a piece of that company.
But here’s the catch: these companies are a bit like roller coasters. They can go up really fast, but they can also drop down quickly. This means they’re not as steady or predictable as other companies. Because everyone expects them to do so well, if they don’t live up to those big expectations, the price can fall a lot.
So, while these “treasure chest” companies might seem super promising, they also come with risks. Sometimes, people think they’re so promising that they’re actually priced too high for what they’re really worth. It’s like saying that, in all the excitement, people might be paying more than they should for a ticket to ride that roller coaster.
Basically, investing in these kinds of companies can be like aiming for big rewards, but it’s also a riskier game compared to investing in steadier companies.
When a company’s Price Earnings Ratio (P/E ratio) is low, it’s often seen as a good deal. This happens because the stock price is lower compared to how well the company is actually doing. It’s like getting something valuable for a cheap price.
People might buy these stocks because they think the market made a mistake and undervalued them. Then, when more people realize this and the stock price goes up, those who bought it earlier can sell it for a higher price and make a profit.
These kinds of undervalued stocks are often found in older industries that regularly pay dividends to their shareholders.
Dividend Yield
The company’s Dividend Per Share is divided by Per Share Price to get the dividend yield. The dividend yield formula helps figure out the money you get from owning stocks in a company. It shows the part of the company’s earnings given to investors for each dollar they put into stocks. Whether it’s a high or low yield depends on things like the type of business and how old the company is. For instance, a fast-growing company might not pay dividends because they use that money to make the business bigger. On the flip side, a company that’s been around for a while might pay out more dividends since it might not grow as much in the future.
Dividend Yield = Dividend Per Share /Price Per Share
The dividend yield doesn’t say if a company is good or bad. Instead, it helps investors choose stocks that match what they want for their investments.
Dividend Yield = Dividend Per Share / Price Per Share
These are some of the matrices you can use to evaluate and compare companies based on their Share Price.
Enterprise Multiples
Since Enterprise value is the most important metric to value a company, multiples using enterprise value further extend the analysis, enable comparisons among companies, and give a clearer picture of which company is the best. The EV/EBIT ratio is a helpful tool for investors in the stock market. If the ratio is high, it suggests that a company’s stock might be too expensive. This can be good for selling shares quickly to make a profit, but it could be risky if the market changes, causing stock prices to drop suddenly. On the other hand, a low EV/EBIT ratio indicates that a company’s stock might be priced lower than its true value. When the market corrects this undervaluation, the stock prices and the company’s overall financial health could improve.
Enterprise Value = Market Capitalization + Debt + Minority Interest + Preferred Stock - Cash & Cash Equivalents
Understanding a company’s enterprise value is crucial because it gives a clear picture of its actual worth in the market. This is particularly important for potential buyers looking to acquire the company or for those trying to estimate the cost of a possible takeover.
The cost estimate is useful for a firm if it is considering buying another firm or if a takeover is imminent. Investors primarily utilize a company’s enterprise multiple to assess if it’s undervalued or overvalued. A lower ratio compared to its peers or past averages suggests potential undervaluation, while a higher ratio suggests potential overvaluation. Whether it is good or bad depends upon the industry of the company. The enterprise multiple proves valuable in international comparisons by disregarding the influence of distinct taxation policies within countries. It’s seen as a superior method of evaluating mergers and acquisitions compared to market capitalization because it takes into account the debt that the acquiring company would need to take on and the cash they would gain, making it a superior metric for merger and acquisition (M&A) considerations compared to market capitalization.
Let us remember the formula of EV,
Enterprise Value = Market Capitalization + Debt + Minority Interest + Preferred Stock – Cash & Cash Equivalents
Some of the Enterprise multiples are given below:
EV/Revenue
Here Enterprise Value is divided by Revenue of the company. This may be used in scenarios where the company doesn’t have positive EBIT or EBITDA or Net Income.
EV/Revenue = Enterprise Value / Total Revenue
In some cases when the company is in the initial stages of operation and operating at a loss or it is a high-growth company operating at a break-even point, EV/Revenue can be used for valuation.
EV/Revenue = Enterprise Value / Total Revenue
A greater EV/Revenue ratio than rivals suggests that the market has confidence in the company’s ability to generate revenue more effectively in the future, hence they’re willing to pay extra for each sales dollar. For investors seeking undervalued opportunities, particularly in publicly traded stocks, a lower EV/Revenue ratio signifies a more favourable scenario. It can indicate a potential undervaluation of the company, making it an attractive investment prospect with the possibility of higher returns.
EV/EBIT
The proportion of Enterprise Value and Earning Before Interest and Taxes is calculated here.
EV/EBIT = Enterprise Value / Earning Before Interest and Taxes
It is useful for companies that are highly capital-intensive depreciation is a major part of all expenses. We should be aware of the adjustments we make to EBIT. Companies reduce non-cash expenses/one-time expenses which are non-recurring in nature while calculating EBIT. This includes Insurance claims, government grants, disposal of assets, inventory write-downs, COVID-related expenses, etc. These are added back to calculate Adjusted EBIT which should be used while calculating the multiple.
EV/EBIT = Enterprise Value / Earning Before Interest and Taxes
The EV/EBIT ratio is a helpful tool for investors in the stock market. If the ratio is high, it suggests that a company’s stock might be too expensive. This can be good for selling shares quickly to make a profit, but it could be risky if the market changes, causing stock prices to drop suddenly. On the other hand, a low EV/EBIT ratio indicates that a company’s stock might be priced lower than its true value. When the market corrects this undervaluation, the stock prices and the company’s overall financial health could improve.
EV/EBITDA
Enterprise Value is divided by Earning Before Interest, Taxes, Depreciation, and Amortization. This shows how often EBITDA an acquirer will have to pay when it acquires the complete business. The more the capital expense of the company, the more will be the base for calculation i.e. EBITDA, and the lower the multiple will be.
EV/EBITDA = Enterprise Value / Earning Before Interest, Taxes, Depreciation, and Amortization
EV/EBITDA = Enterprise Value / Earning Before Interest, Taxes, Depreciation, and Amortization
For eg.
Keeping EV of $100M and EBIT of $30M constant for all companies, EV/EBIT = 100/30 = 3.3x. Now multiple is the same for all the companies, then how to differentiate among the companies as to which one is doing good and which one is doing bad?
Now, Let’s understand this by adding Depreciation and Amortization (D&A) to EBIT and comparing all those where D&A varies according to its capital intensity.
D&A of Company A whose capital intensity is Low – $10M
D&A of Company B whose capital intensity is Medium – $20M
D&A of Company C whose capital intensity is High- $30M
Now, calculating the EV/EBITDA of all the companies:
Company A – 100/(30+10) = 2.5x
Company B – 100/(30+20) = 2x
Company C – 100/(30+30) = 1.6x
So, in the example, we saw that as depreciation and amortization increased with the capital intensity of the company, the EV/EBITDA multiple kept on decreasing. The multiple is calculated for other companies in the same industry too.D&A in all the companies would be at the higher end and the multiples of all companies in that industry would have been affected due to this. Thus, capital intensity would not be too prevalent factor while calculating multiples here.
EV/EBITDAR
Enterprise Value is divided by Earning Before Interest, Taxes, Depreciation and Amortization and Rental Cost/Leases. Adding rent or lease costs into EBITDAR enhances the relevance of EV/EBITDAR, especially in industries like transportation, hospitality, and retail where leasing assets are prevalent. This integration ensures that significant expenses related to rent or lease are considered in the assessment, thereby offering a more precise evaluation of a company’s profitability.
EV/EBITDAR = Enterprise Value / Earning Before Interest, Taxes, Depreciation and Amortization and Rental Cost/Leases
A higher ratio implies a pricier valuation concerning earnings, while a lower ratio indicates a more modest valuation. This metric’s significance varies based on industry specifics: a lofty ratio might signal an overvalued company or high investor expectations for future growth, whereas a lower ratio could imply undervaluation or operational hurdles.
EV/EBITDAR = Enterprise Value / Earning Before Interest, Taxes, Depreciation and Amortization and Rental Cost/Leases
Crucially, industries differ in capital needs, affecting their typical EV/EBITDAR ratios. Sectors like manufacturing may show lower ratios compared to tech or software fields due to higher capital demands. Hence, comparing ratios within the same industry is key for meaningful analysis. Pairing the EV/EBITDAR ratio with other financial metrics allows analysts and investors to glean comprehensive insights into a company’s worth, aiding more informed investment decisions.
Also, EV/EBITDAR is a significant instrument in evaluating and analyzing industries. It enables analysts to pinpoint exceptional cases and potential investment prospects by evaluating EV/EBITDAR ratios among companies within the same sector. Nonetheless, it’s pivotal to acknowledge industry-specific nuances while utilizing EV/EBITDAR for benchmarking. Industries differ in capital needs, operational frameworks, and leasing arrangements, resulting in disparities in EV/EBITDAR metrics. Thus, comprehending industry intricacies and employing industry-specific benchmarks are crucial when conducting comparative assessments.
EV/Invested Capital
Enterprise Value is divided by Invested Capital. Mostly used in companies which are highly capital-intensive or where capital investment is higher in comparison to companies of other industries.
EV/Invested Capital = Enterprise Value / Invested Capital
EV/Invested Capital = Enterprise Value / Invested Capital
There are 2 methods of calculating invested capital.
- Operating Approach where Invested Capital is calculated using the Net Working Capital, Plant, Property & Equipment and Goodwill & Intangibles Assets.
Invested Capital = Net Working Capital + Plant, Property & Equipment + Goodwill & Intangibles Assets
Where Net Working Capital = Current operating assets – Non-interest bearing current liabilities.
Invested Capital = Net Working Capital + Plant, Property & Equipment + Goodwill & Intangibles Assets
Net Working Capital = Current operating assets – Non-interest bearing current liabilities
First, Net working capital is calculated by reducing Non-interest-bearing current liabilities from Current operating assets. Then, add Property & Equipment and Goodwill and intangible assets. Goodwill and intangible assets are added separately to the formula. Then, it calculates the invested capital by adding all elements together.
- Financing Approach where Invested Capital is calculated using Total debt and leases, Total Equity and Equity Equivalents and Non-Operating Cash & Investments.
Invested Capital = Total debt & Leases + Total Equity and Equity Equivalents + Non-Operating Cash & Investments
Invested Capital = Total debt & Leases + Total Equity and Equity Equivalents + Non-Operating Cash & Investments
To find the Total debt & Leases, add up the short-term debt, long-term debt, and the present value of lease obligations. Then, to figure out the money invested by owners, add together the common stock and retained earnings. Finally, to calculate the money not used for daily operations like cash from loans and investments, add the cash from financing and cash from investing. The final step is to add all three sums together to get the total invested money.
Relative to other measures of a company’s worth, like EV/EBITDA or EV/EBIT, the employment of the EV/invested capital ratio is less frequent. This particular ratio finds its greatest utility in businesses reliant on substantial capital investment, where both past and future earnings heavily rely on the effectiveness of fixed assets. In times of industry-wide fluctuations, especially in capital-heavy sectors like oil and gas, the EV/IC ratio tends to exhibit more steadiness. Unlike metrics such as P/E or EV/EBITDA, which can be skewed by market conditions, the EV/IC ratio has historically stood as a more self-reliant and thus more dependable measure of current market valuation.
However, a key drawback of this measure is that investing in growth is subjective, meaning a high valuation doesn’t automatically mean the company is overpriced. The market is considering the company’s ability to capitalize on its customer base more effectively, which involves risk but can also yield substantial gains.
SUMMARY
To summarize what we have learnt so far..
Multiples in finance refer to ratios used to compare different aspects of a company’s performance, aiding in the evaluation of its worth relative to its industry peers. There are two main categories of multiples: Equity Multiples and Enterprise Multiples.
Equity Multiples focus on stock-related metrics:
1. Share Price/Sales: Compares a company’s market value to its sales, helping to gauge how investors value the company based on its revenue without delving into intricate financial details.
2. Share Price/Book Value of Assets: Compares a company’s market value to the value of its assets, assisting investors in determining if a stock is priced fairly in relation to what the company owns.
3. P/E Ratio (Price-to-Earnings Ratio): Divides a company’s share price by its earnings per share, providing insight into how much investors are willing to pay per dollar of earnings. This metric aids in understanding stock valuation relative to earnings.
4. Dividend Yield: Divides a company’s dividend per share by its share price, revealing the return on investment from dividends and helping investors choose stocks aligned with their investment goals.
Enterprise Multiples offer a broader view of a company’s value:
1. EV/Revenue (Enterprise Value/Revenue): Divides a company’s enterprise value by its revenue, particularly useful for companies without positive earnings or when assessing high-growth businesses.
2. EV/EBIT (Enterprise Value/Earnings Before Interest and Taxes): Analyzes a company’s enterprise value against its earnings, indicating whether a stock may be overpriced or undervalued based on its profitability.
3. EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization): Considers earnings before certain expenses, offering insights into a company’s operational efficiency and financial health.
4. EV/EBITDAR (Enterprise Value/Earnings Before Interest, Taxes, Depreciation, Amortization, and Rental Costs): Integrates rental costs/leases into EBITDA, especially relevant in industries where leasing assets are prevalent.
5. EV/Invested Capital: Divides enterprise value by invested capital, more commonly used in capital-intensive industries to assess the effectiveness of fixed assets.
Understanding these multiples requires an in-depth understanding of the company, its industry, and specific financial contexts. Investors often use multiples for comparative analysis, seeking undervalued stocks for potential higher returns or for making informed investment decisions.
