My name is Han Smit. I'm a professor of Corporate Finance at Erasmus School of Economics. In this webcast, you will learn to perform a valuation using multiples. While multiples valuations are liked for their relatively simple and quick approach to estimating value, they must be seen as a final complementary check to a discounted cash flow valuation. After this webcast, you will understand when to apply the different types of multiples and you will know how to calculate the value of a company using multiples valuation. With a multiples valuation, or relative valuation, you are able to estimate the value of a privately owned company based on the prices of comparable firms. A multiple is essentially a quotient, relating the market value or price to a key statistic, usually a measure of profitability. In multiples valuation, we start by creating a peer group, which is a list of comparable firms. Then the average or median multiple of this peer group and the profitability of the target company provides us with an estimate of our company's value. A multiples valuation assumes that the observed price of a similar company or asset is a good estimate of the value of the target company. Whether a peer group is indeed comparable can be based on similarities of the risk profile, leverage, growth expectations, or size. We generally distinguish between two <i>classes</i> of multiples: trading and transaction multiples. With trading multiples you use prices for which comparable firms are traded in the market to estimate value. Transaction multiples use the prices paid for other comparable companies that were previously acquired as a proxy for value. Multiples can also differ but time period they are based on. Historical multiples relate current values to historical results, trailing multiples relate current value to the past 12 months results, and forward-looking multiples relate value to forecasts. The latter are often preferred over historical or trailing multiples, since you typically want to value a company based on what you expect going forward. Within each class of multiple, there are also different <i>types</i> of multiples. So, now a quick question to you: Can you think of some of the advantages or disadvantages of each class of multiples? Most common are earnings multiples, such price-to-earnings or enterprise value over EBITDA multiples, which relate the value of a company to a measure of its gross profitability. Especially the latter is a popular multiple, because it is relatively robust and less distorted by differences in accounting conventions or the leverage of the firm. Another type are sales multiples, for instance, price-to-sales. This type is often used for companies with negative earnings, such as startups and new ventures. Next, are market-to-book multiples. For example, market capitalization-to-book value of equity or alternatively market price-to-book value per share. A drawback of this type is that it doesn't take into account the actual returns that are made on the equity or assets, and it can be distorted by accounting conventions. Lastly, industry-specific multiples are used, which relate value to some industry-specific metric. For instance, social media companies, such as Twitter, provide completely new business models. For Twitter, value is driven largely by the number of users. Therefore, a more informative way to determine the value Twitter creates is by looking at value per user account. Do you now have a better idea of the advantages and disadvantages of different classes and types of multiples? Well now that we explained the different classes and types of multiples, let's have a look at a simplified example of a multiples valuation. So, consider a US-based telecom company, Telco, that wants to sell its wireless tower network business. The value will be based on multiples of a peer group: the price-to-earnings, enterprise value-to-EBIT, enterprise value-to-EBITDA and enterprise value to the number of towers. First, we want to take a look at the average, or alternatively the median, of all companies per type of multiple. Because we don't see any significant outliers in this case, we want to stick to averages. Second, we multiply these average multiples with the relevant statistic of our own company. For instance, we multiply the average value-to-EBIT multiple, 19.11, with our company's EBIT of 18 million. This gives us an enterprise value of approximately 344 million for Telco's tower network. Using the EBITDA multiple, we multiply 14.7 with our company's EBITDA of 25 million to obtain an enterprise value estimate of 367.5 million. Using the same method with the average of value per tower multiple, yields an estimated enterprise value of 382 million. Lastly, applying the average price-earnings multiple to Telco's earnings results in an estimated equity value of 31.25 times five, is 156.25 million. Be warned: because the price-earnings multiple already takes into account the capital structure, it yields an estimate of the company's <i>equity</i> value and not the <i>enterprise</i> value. To obtain the enterprise value, you must still add Telco's debt, which is 200 million. Therefore, using the price-earnings multiple yields an estimated enterprise value of 356.25 million. With the other multiples, you obtain the enterprise value directly. For more detailed examples on how to use trading or transaction multiples, please see the provided documentation. One of the main limitations of multiples valuation is that the method provides a relative measure of value based on prices and therefore you implicitly make the assumption that the price paid is equal to fundamental value and that markets are efficient. But that doesn't always have to be the case, as the excessive valuation of tech companies during the dot-com bubble of the early 2000's may have have demonstrated. Furthermore, comparability is crucial, but finding a perfect twin is extremely difficult. In order to truly understand and trust comparability, we will need to look closer at the fundamentals behind the multiples. This will help us understand why multiples can differ across firms that are similar in size and which are active in the same industry. For example, let's look at the price-earnings ratio calculated as the price over earnings. The price can be considered as the present value of future dividends, or when using the constant growth model, the next year's dividend divided by the cost of equity minus the expected growth rate. When we rewrite the PE ratio by substituting equation two into equation one, we get that the PE ratio equals the dividends divided by the cost of equity minus the expected growth rate, all over earnings. We can then rewrite this as the payout ratio (which equals the dividends divided by earnings) over the cost of equity minus the expected growth rate. Thus the PE ratio can be decomposed into a payout ratio, cost of equity, and the expected growth rate, and the difference in PE ratios between companies can be explained by differences in these three factors. When you want to use multiples to value a company, you should try to correct for these differences in order to get cleaner comparisons. Normalizing multiples is a way to do that. For instance, the PE ratio can be normalized for differences in growth, when you calculate the price earnings-to-growth ratio, or PEG ratio. You could also normalize the enterprise value-to-sales for differences in profitability by taking the enterprise value-to-sales over the operating margin. To summarize our discussion: multiples valuation should be used as a complementary valuation method and be supported by other valuation approaches. We have discussed the different classes and types of multiples and we understand their advantages and disadvantages. This allows us to choose multiples which are more appropriate depending on the circumstances. A company valuation can be based on a combination of DCF and multiples. But the ultimate valuation judgment should also involve strategic aspects, such as: the strategy of the firm, the quality of management, the competitive position, and the industry attractiveness, or the speed of innovation. In the next series of webcasts you can learn how to estimate these aspects, and their effect on company value. I hope to see you in the next series. Thank you for watching this video.
