Market Multiples Approach to Valuation

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From the course by University of Illinois at Urbana-Champaign

Investments I: Fundamentals of Performance Evaluation

412 ratings

University of Illinois at Urbana-Champaign

Investments I: Fundamentals of Performance Evaluation

412 ratings

Course 3 of 7 in the Specialization Financial Management

In this course, we will discuss fundamental principles of trading off risk and return, portfolio optimization, and security pricing. We will study and use risk-return models such as the Capital Asset Pricing Model (CAPM) and multi-factor models to evaluate the performance of various securities and portfolios. Specifically, we will learn how to interpret and estimate regressions that provide us with both a benchmark to use for a security given its risk (determined by its beta), as well as a risk-adjusted measure of the security’s performance (measured by its alpha). Building upon this framework, market efficiency and its implications for patterns in stock returns and the asset-management industry will be discussed. Finally, the course will conclude by connecting investment finance with corporate finance by examining firm valuation techniques such as the use of market multiples and discounted cash flow analysis. The course emphasizes real-world examples and applications in Excel throughout. This course is the first of two on Investments that I am offering online (“Investments II: Lessons and Applications for Investors” is the second course). The over-arching goals of this course are to build an understanding of the fundamentals of investment finance and provide an ability to implement key asset-pricing models and firm-valuation techniques in real-world situations. Specifically, upon successful completion of this course, you will be able to: • Explain the tradeoffs between risk and return • Form a portfolio of securities and calculate the expected return and standard deviation of that portfolio • Understand the real-world implications of the Separation Theorem of investments • Use the Capital Asset Pricing Model (CAPM) and 3-Factor Model to evaluate the performance of an asset (like stocks) through regression analysis • Estimate and interpret the ALPHA (α) and BETA (β) of a security, two statistics commonly reported on financial websites • Describe what is meant by market efficiency and what it implies for patterns in stock returns and for the asset-management industry • Understand market multiples and income approaches to valuing a firm and its stock, as well as the sensitivity of each approach to assumptions made • Conduct specific examples of a market multiples valuation and a discounted cash flow valuation This course was previously entitled “Financial Evaluation and Strategy: Investments” and was part of a previous specialization entitled "Improving Business and Finances Operations", which is now closed to new learner enrollment. “Financial Evaluation and Strategy: Investments” received an average rating of 4.8 out of 5 based on 199 reviews over the period August 2015 through August 2016. You can view a detailed summary of the ratings and reviews for this course in the Course Overview section. This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

From the lesson

Module 4: Investment Finance and Corporate Finance: Firm Valuation

In Module 4, we will learn about the two key approaches to valuing a company or stock: market multiples and discounted cash flow. We will learn how to value perpetuities and will discuss how caution should be exercised in terms of projecting both the growth in long-term cash flows and the riskiness of those cash flows – two key components of the perpetuity formula. Finally, to gain experience with the market multiples approach, we will estimate a value of Google at the time of its initial public offering (IPO) back in 2004 using market data on Yahoo! as a comparable firm.

Market Multiples Approach to Valuation9:11

Income Approach to Valuation: Introduction17:37

Income Approach to Valuation: Discount Rate17:54

Income Approach to Valuation: Cash Flows8:52

Income Approach to Valuation: Terminal Value, Price-to-Earnings Ratio, & Discounting of Cash Flows19:00

Fudge Factors to Valuation and What We've Learned6:43

Meet the Instructors

Scott Weisbenner
William G. Karnes Professor of Finance
Department of Finance, College of Business

[ Intro Music ]

>> So in this video let's discuss the market multiple's

approach to valuation, also known as comparable analysis.

So the basic idea behind market multiples is

to find a comparable company that should be valued similarly

to your firm along various financial metrics.

You know, such financial metrics include both market value data

and financial accounting data such as, you know,

a price-to-earnings ratio.

A market-to-book ratio.

So the key idea is, find a firm that is comparable to you.

Should be valued in the same way that your firm is valued.

See how that firm is valued.

Apply that market-to-book, or price-to-sales

or price-to-earnings ratio of your competitor.

Multiply by it your book value or your earnings or your sales,

to get an estimate of what your market value would be

if you were valued the same way by the market

as your comparable firm.

That's market multiple analysis in a nutshell.

Key assumption.

These comparable companies have future cash flow expectations

and risk.

They're similar to the firm being valued.

So this sounds easy in theory, but it's more difficult to,

you know, kind of do in practice.

So for example, using General Motors is a comparable firm

for Tesla, probably doesn't make as much sense

as using General Motors as a comparable firm for Ford.

Okay? So easy in theory; difficult in practice.

How do we compute these comparables?

How do we do this comparable analysis?

So first, let's start with a sample of firms whose business

and financial characteristics are similar

to the company being valued.

Let's assume that that company has similar financial ratios

to the comparable firms.

So, for example this could be price-to-earnings.

Market-to-book.

Total firm market value over sales.

You know, total firm market value

over earnings before interest and taxes.

You kind of get the drill.

We just have some financial ratio

where it's a market value divided

by some accounting number.

That's a, you know, the kind of market multiple we'll use.

And we'll take that market multiple

from the comparable company,

apply that to our accounting data

to get an estimate of our market value.

And when we do this, we need to remember, are we interested

in getting total firm value?

Are we interested in just getting the part of firm value

that will go to equity holders?

So if we come up with an estimate of total firm value,

if we care about the amount that's going

to the stockholders, we'll need to, you know, kind of subtract

out the amount that goes to the debt holders

to get to the stockholders.

So just remember, total firm market value equals the claims

of the bondholders, and the claims of the stockholders.

Okay. When is a natural time

to use this market multiple approach.

Okay? A natural application for market multiples is a valuation

of a company right before it's having an initial

public offering.

You can obviously do discounted cash flow analysis at any time,

whether the firm is public or private.

But if it's private firm, there is no --

by definition there is no publically traded market price.

So maybe a way to get a sense of market conditions;

market sentiment is find a comparable firm that's already

publically traded.

Is already on the New York Stock Exchange or NASDAQ

or London Stock Exchange.

See how the market values that firm.

Apply that valuation ratio to your own accounting data

to get a sense of how the market would value you, okay?

So this is a way to kind of gain insight about market sentiment

for a firm that's not yet publically traded.

You can also use a market multiples approach

for publically traded firms.

Firms that already have a stock price.

You may think, hey, the market is under-valuing my firm

and the cash flow it generates.

It can kind of give a sense

when you're doing a market multiple analysis, is your,

you know, kind of market value kind of correct?

Is your, you know, kind

of current market value too high or too low?

If you think there's other firms

that should be valued the same way you are,

you do a market multiple analysis.

And those firms imply that your stock should be

at a higher level, maybe that's a suggestion

that you're under valued.

Maybe you should consider, you know, a leverage buyout

or maybe less dramatic, repurchase some of your stock

if you think you're undervalued by the market, for example.

You may think about doing this market multiple analysis

if you're subject to a takeover bid to get a sense of like, hey,

what's a fair, you know, kind of a price to demand

from the firm that's seeking to acquire you, for example.

So market multiple, useful for both private firms as well

as publically traded firms to get a sense

of market sentiment, okay?

So once we get this estimate from the, you know,

kind of market multiples technique, we need to --

we can think about comparing that to the answer

from discounted cash flows.

So we can look at the valuation from market multiples.

We can compare that to the valuation we get

from simply doing a discounted cash flow analysis.

So natural question is, what if the two approaches differ?

You know, market values, are they stirring from fundamentals?

If you get, kind of the market multiple answer that is higher

than your discounted cash flow, is that kind of a suggestion

that like, hey, you know, kind of the market value

of your company is higher, that could be justified

by the discounted cash flows.

Maybe it's a good time to sell stock.

Good time to have an IPO.

If the reverse is true that the market value implied

by the market multiple technique is lower

than their discounted cash flow analysis,

maybe that's a good time you're under-valued.

To repurchase stock; do a leverage bye-out.

So maybe you're picking up some clues

about market sentiment, okay?

Market value straying away

from the fundamental cash flow value of the company.

On the other hand, it could just simply mean

that you screwed up [laughter].

That your market-multiple,

comparable company wasn't really comparable.

Or that, you know, your cash flow assumptions were wrong.

So if the market multiple

and the discounted cash flow technique differ,

could represent, hey, some market forces.

You know, market prices stirring from fundamentals.

Or it could just simply reflect that you've kind of screwed up.

Made bad assumptions in one or both valuation techniques.

And that's why the answers aren't comparable.

So that's where the being, you know,

kind of approximately right, versus precisely wrong comes in.

Problems or limitations, I should say, with you know,

kind of the market multiple's approach.

We've kind of talked about this.

You know, it's easy to do in theory,

but in practice can you really find

that truly comparable company to do the comparison with?

Which ratio should you use?

Okay? No one, right answer.

You know, should you use price-to-earnings?

Price-to-sale?

Market-to-book?

You know, which one should you pick?

No reason you have to limit yourself to,

you know, just kind of one.

Sensitivity analysis is important here

to see what values are implied by multiple -- market multiples,

to kind of get some sense.

You don't want to just kind of rely on one.

You want to get some sense of the distribution of, you know,

kind of estimates you get across a lot

of different reasonable market multiple valuations.

Okay? Another thing to consider

with the comparable's approach is does a comparable company

have a different capital structure than you do?

Leverage. Having more debt leads to more interest payments, okay?

Leverage can mechanically affect some financial ratios

such as a price-to-earnings, where earnings is net income.

Because interest is deductible from net income.

So, you know, generally a good idea is to use market ratios

that are not affected by leverage.

So you don't have simple differences in leverage.

Financial structure of the company,

affecting the market multiples.

Other things you need to, you know, kind of be thinking about.

What kind of investments does the firm do?

A firm that does research

and development may have different patterns

in reported earnings than a firm that does capital expenditure,

due to the different rules for expensing

of those different types of investments.

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