0:08

Welcome back.

Â We are talking about multiples and

Â in the next segment I'm going to provide you enough detail that we can conclude.

Â Please remember what we talked about is that we started out with the firm with

Â no debt to make things simple when you use multiples you pick

Â compatibles in the same business with similar growth.

Â We then started worrying about what in the real world is used.

Â It's good to talk about theory.

Â 0:37

We realized that a lot of people used price to earnings multiples simply because

Â free cash flows are choppy, and earnings are literally available.

Â Having said that, you have to remember that earnings are not free cash flows.

Â They are less choppy bu,t they're not free cash flows.

Â So you to worry about some issues with earning and see how they behave.

Â But most importantly, you have to adjust for

Â growth which is the approximate adjustment of the for the b bag ratio.

Â And you have to worry a lot about debt.

Â 1:11

So as long as there was no debt, P ratios can be more or

Â less used because the effects of leverage are complicated.

Â And if there's no leverage you don't have to worry about it.

Â But the real world has leverage.

Â So you go, you want to start a new firm called Orange, or

Â you're going to start a firm very similar to a retail business.

Â Call it whatever you want.

Â You want to look comparables.

Â And you find comparables in the same business, similar growth and so

Â and so forth.

Â But you can't use PE ratios because they're contaminated.

Â So what's the alternative?

Â 2:01

E-B-I-T-D-A.

Â Earnings before interest, taxes, depreciation, and amortization.

Â We have talked about this a lot.

Â So I'm just going to say it.

Â I'll show you some numbers in a second.

Â So though P/E ratios is most commonly quoted in the financial

Â press in valuation, given that data's fairly frequently used.

Â Enterprise value multiples are much more widely used.

Â What is enterprise value?

Â Enterprise value is the value of the whole firm.

Â 2:34

Not just the value of equity, itÂ´s the value of equity plus debt and

Â weÂ´ll see that you subtract the value of excess cash flows.

Â And IÂ´m going to talk about that briefly here and

Â not too much in detail because excess cash flows.

Â Think of them as cash flows you have, which have nothing to do with your current

Â business, but you may be carrying them to invest in some future businesses.

Â So enterprise value is the value of equity plus debt.

Â And typically if you have excess cash flow, you subtract it.

Â So, that's the numerator.

Â Instead of price, enterprise value.

Â But the denominator has to change as well, so what do you have?

Â EBITDA.

Â Remember, you haven't subtracted interest and

Â you haven't subtracted depreciation and amortization and taxes.

Â So this is the most commonly used.

Â Again, the logic being it's less choppy.

Â Then free cash flows, which can also be negative, right?

Â 3:32

So that's the multiple we'll talk about.

Â Enterprise value divided by EBITDA.

Â Again, if you look at the screen.

Â I have defined Enterprise Value as equity plus debt minus excess cash.

Â 3:46

How does this change with leverage?

Â So how does this ratio, enterprise value over EBITDA, change with leverage?

Â Well, think about it.

Â It is still contaminated somewhat.

Â So leverage, though distinctly is not being accounted for

Â in EBITDA, the denominator, because we kept interest there.

Â You know enterprise value will increase with leverage, right?

Â Because, what happens?

Â The same way as equity value goes up,

Â because of the subsidy provided by the government, for

Â the interest payment on debt, effects value of the whole firm as well.

Â 4:25

So some thoughts on it.

Â Ideally, what would you do about enterprise value?

Â You would try to remove present value of the tax shields,

Â and also try to remove the effects of financial distress, okay?

Â So that you're left with a pure kind of value of

Â the very tough to do in real world.

Â So we tend not to do it.

Â It's very, very tough to do all this.

Â 4:52

EBITDA, however, so

Â that's enterprise value, EBITDA also has some non-operational items, right?

Â So for example, if you have operating leases.

Â The rental expense includes interest costs.

Â 5:25

For both enterprise value and EBITDA.

Â So I've just highlighted some of the things that you need to worry about

Â to adjust given enterprise value and EBITDA multiples.

Â But at least they don't suffer as much as PE

Â ratios blatantly suffer from leverage.

Â Okay?

Â And we just want to give you an example to end it all so

Â that you understand what it's all about.

Â So I'm going to put up some numbers.

Â And we'll give you all this information for you to stare at and

Â we'll do calculation.

Â These are real world numbers.

Â So what I did was on November 4th, 2014.

Â I was just fooling around creating this slide, and

Â I took some information and the following data was available on Apple.

Â The market capitalization of Apple if you stare was about $636.92 billion.

Â A lot of money.

Â But Apple is doing pretty well.

Â So market capitalization.

Â What does that mean?

Â It's the value of the stock, remember?

Â We have done all this in the specialization.

Â So market capitalization means value of the equity.

Â 6:39

Debt from the balance sheet is 35.30 billion.

Â You notice that Apple doesn't have too much debt, but

Â it's not zero either, right.

Â So I've just taken this number from the balance sheet.

Â Again going back to all the valuation we have done.

Â I want to remind you that sometimes we have to take numbers from the balance

Â sheet because debt doesn't trade every day.

Â So many times you have to deal with book value.

Â Turns out, excess cash I calculated.

Â This is cash sitting around,

Â which has nothing to do with the fundamental existing business of Apple.

Â So you excess cash about 20.47 billion.

Â 7:17

Please jot down these numbers as we go about.

Â And enterprise value is 65, 651.75 billion.

Â I will not tell you how I calculated it, it's pretty straightforward,

Â given all the numbers.

Â What do you do?

Â 7:34

Equity plus debt, minus excess cash.

Â So I have given you a number for enterprise value,

Â which is the numerator off a multiple based on EBITDA.

Â So let me give you the EBITDA number.

Â 7:49

The EBITDA number turns out to be 60.45 billion.

Â Do you have all the information out there?

Â Stare at it.

Â We are now going to take a break,

Â because these calculations are pretty straightforward.

Â But I would like you to just make sure you jotted down all the numbers.

Â One more time, 636 billion approximately is value of equity.

Â 35 billion approximately is value of debt.

Â 20, 21 billion approximately is value of excess cash flow.

Â Therefore enterprise value turns out to be about $651.75 billion.

Â 8:26

EBITDA, which is easy to figure out from the accounting statements,

Â turns out to be and on that specific date, 60.45 billion.

Â Okay?

Â Let's assume that,

Â that's the EBITDA for next year, just to be sure that we are doing it right.

Â So what is the Enterprise Value over EBITDA multiple for

Â Apple on that specific day.

Â 9:14

I'm approximating because we are friends.

Â It's actually 651.75.

Â And this is equal to approximately how much?

Â 60.5 billion.

Â Okay, it's actually 60.45, but we are friends.

Â Do the ratio and it will work out to be about 10.78.

Â If you think about it for a second, take a couple of minutes to look at it.

Â What does this ratio mean?

Â It's the value of the firm relative to an observable.

Â Remember, at the beginning?

Â Multiples are all value, relative to an observable.

Â So the observable is EBITDA, 60.5, value of the firm 652, so

Â the multiple is 10.78.

Â Now let's do one more thing, and you will see.

Â Suppose I want to figure out continuation autumnal value for

Â Apple ten years from now.

Â Let's go ten years in to the future and try to forecast stuff.

Â So let's assume that the forecast of EBITA you

Â have done is going to be $91.5 billion.

Â So what's the value of EBITDA?

Â Ten years from now you think it's going to be 91.5.

Â How do you come up with the number?

Â You obviously assume some growth rate,

Â which is realistic and not just pulled out of thin air.

Â You do a lot of research, and we have done that, and

Â we've come up with a number of 95.5 billion.

Â We're assuming that the firm is going to grow.

Â 10:51

So what is the value using the current EBITDA of Apple ten years from now?

Â So assuming that the ratio of enterprise value to EBITDA remains the same at 10.78.

Â What is the value of the firm projected to be on app.

Â Remember the observable you first project and then you use the ratio.

Â Very simple.

Â And this is the beauty of multiples.

Â You just multiply 10.78 by 91.50.

Â Why?

Â Because you know and if I may write it again.

Â It is the EV over EBITDA

Â multiple multiplied by

Â EBITDA but in which year?

Â Year ten.

Â So you just 10.78, you know this number and you know this ratio.

Â The assumption you're making that the ratio remains the same, right?

Â So in life you make all these assumptions.

Â What is the value of the firm?

Â Almost a thousand billion dollars.

Â So, basically this is what the value of the firm will be in the future.

Â And I hope you get a sense of how I got there.

Â 12:11

And, you find the use of multiples in a small context.

Â The nice thing about multiples is they're extremely simple.

Â But we did a lot of work on the logic behind them.

Â I want to comment a little bit on this issue, because many times

Â people in academia think multiples are too simple and heuristic.

Â That the real world uses all the time.

Â 12:35

Yes, that's true.

Â But on the other hand, to discard them outright and

Â say they don't make sense is discarding the logic of discounting cash flows.

Â Remember, how did we value, how did we figure out how multiples are determined?

Â We used c over r minus g essentially to figure out where multiples come from.

Â So multiples are inherently embedded and based on discounted cash flows.

Â They're simple because we use simple formulas.

Â 13:08

But having said that, don't just run with multiples.

Â You got to take care of leverages, growth, similar businesses,

Â similar business risk Be very careful when you're using simple numbers.

Â 13:21

And to back up your analysis, use multiples, but

Â always use discounted cash flows in detail.

Â The more you can forecast, the better discounted cash flows are.

Â The less you know about the future, then rules of thumb are more useful, right?

Â So multiples can be useful in a world where you do not know things

Â with precision,

Â which is often happens in the VC world or in the world of high uncertainty.

Â