This study addresses the differences between firms and the impact on valuations based on multiples. It broadly describes the need for relative valuation which is increasingly used in assessing individual business or corporations. On a theoretical level, it captures the advantages and shortcomings of multiples. It also describes why the multiples differ from one institution in one sector to another whilst addressing the factors that cause the anomalies. In addition it highlights what the value drivers are behind the multiples and the significant role they play in arriving at multiples. Alongside the paper also details how these value drivers are systematically aligned in producing ...view middle of the document...
There are two basic types of multiple – enterprise value and equity:
2.1.1 Enterprise multiples express the value of an entire enterprise – the value of all claims on a business – relative to a statistic that relates to the entire enterprise, such as sales or EBIT.
2.1.2 Equity multiples, by contrast, express the value of shareholders’ claims on the assets and cash flow of the business. An equity multiple therefore expresses the value of this claim relative to a statistic that applies to shareholders only, such as earnings (the residual left after payments to creditors, minority shareholders and other non-equity claimants).
3. Using valuation multiples
3.1 Relative Valuation – Observed Multiple versus Comparable
There are several ways one can apply multiples in valuation. The common approach is to compare the current multiple to a historical multiple measured at a comparable point in the business cycle and macroeconomic environment. An alternate approach is to compare current multiples to those of other companies, a sector or a market, and compare the current spread between them to a historical spread.
3.2 Relative Valuation – Observed Multiple versus Target Multiple
However, one can also compare a stock’s current multiple to a calculated fair or target multiple. At different points in the business cycle the ‘fair’ and observed multiples are likely to differ. A simple investment strategy would be to sell when the current multiple is above the fair multiple and buy when it is below.
4. Value Drivers
Essentially value drivers are the inputs that have the greatest impact on value and these are the estimates of sustainable margins and revenue growth. To a lesser extent, assumptions about how long it will take the firm to reach a sustainable margin and reinvestment needs in stable growth have an impact on value, as well. In practical terms, the bulk of the value of these firms is derived from the terminal value. While this will creates worry for few, it mirrors how an investor makes returns in these firms. The payoff to these investors takes the form of price appreciation rather than dividends or stock buybacks. Another way of explaining the dependence on terminal value and the importance of the sustainable growth assumption is in terms of assets in place and future growth. The value of any firm can be written as the sum of the two.
Value of Firm = Value of Assets in Place + Value of Growth Potential
For start-up firms with negative earnings, almost all of the value can be attributed to the second component. Not surprisingly, the firm value is determined by assumptions about the latter
4.1 Aligning multiples and value drivers
More common way to look at multiples is to plot them relative to various value drivers. The most frequent comparisons are multiples versus growth in an underlying statistic and multiples to return on capital. in other words, multiples are commonly plotted relative to growth or return on...