Advanced Valuation Lecture 4

Question 1

Remark on multiples vs DCF perspective

Answer 1

Trading multiples represent transactions between minority shareholders on the stock exchange, so they reflect minority pricing. But a DCF assumes control over the FCF (if you do not account for a minority discount), so it takes a control perspective.
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Transaction multiples reflect past deals and include synergy premium, control premium, emotional premium etc. So, transaction multiples are higher than the DCF outcome since the DCF assumes a stand-alone perspective. So, a DCF may be more rational.

Question 2

What is the advantage and disadvantage of forward multiples versus historical multiples?

Answer 2

+ Historical multiples may often be based on reported numbers, which do not account for one-offs. Forward looking multiples typically are normalised.
+ Forward multiples are also consistent with valuation methodology > value is about the future.
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–If you base forward multiples on your own estimated EBITDA for example, your multiple could be biased. If you’re very bullish in the company and the EBITDA is very high, this also creeps into your forward multiple.
–If you look at the 3Y forward multiple, you basically ignore performance differences in Y1 and Y2 for peers.

Question 3

What is a big disadvantage of equity multiples? (like P/E) What is a better multiple to use?

Answer 3

They are distorted by the capital structure of the company. So, comparing equity multiples is very challenging. So one could better use enterprise multiples.
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However, if the capital structure of the peers and the target company are very comparable, equity multiples do a good job!
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For financial institutions you usually use equity multiples, as debt is part of their business.

Question 4

Why do you see low EBITDA multiples for asset heavy businesses? Propose a solution

Answer 4

They have to spend a lot on capex, so only a small portion of the EBITDA turns into cash flow. This converts to a lower EV and a lower EBITDA multiple. (e.g., comps that have own production)
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Asset light have higher EBITDA multiples, as they are able to convert a bigger portion of EBITDA into cash flow. (e.g., comps that outsource production)
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Solution: look at EV/EBIT or EV/EBITA multiples! Depreciation is a proxy for capex, so when you exclude depreciation, you get a better proxy for cash flow generation. Or use EV/(EBITDA - capex)

Question 5

Remark on selecting peer companies for multiples

Answer 5

5-10 is the best number of peers. Narrowing down peer group should be based on value creation fundamentals! This could be EBITDA margins.

Question 6

Companies who do lots of acquisitions have higher/lower EBIT?

Answer 6

Company that does lots of acquisitions have lower EBIT, as they have amortisation charges. The company that grows organically does not have high amortisation, and thus has higher EBIT. So, when comparing these companies, look at EBITA multiples instead of EBIT.

Question 7

What is the multiple on cash?

Answer 7

Extremely high. Cash inflates the multiple of the business. If you look at the P/E multiple of cash, it is included in the market cap (P), but if you generate a very low return on cash (E), the multiple will be sky high. And this drives up the overall PE multiple of the company.
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TAKE AWAY: your cash position has a significant impact on the P/E multiple!!!!

Question 8

Why are FCF multiples not appropriate?

Answer 8

FCF itself is not a good metric because of its erratic nature (e.g., lumpy capex patterns and erratic WOC movements)

Question 9

If the sales multiple values a firm higher than the EBITDA/EBITA multiples, what does this imply?

Answer 9

When using the median sales multiple, you assume all comps have the same profitability margins. But the EBITDA/EBITA multiples value the comp much lower than the sales multiple, which means that the company has much lower margins than the peers.

Question 10

Caveats of transaction multiples:

Answer 10

• Data can be difficult to obtain, unreliable and inconsistent across different sources
• Multiple paid is driven by the context of the deal
• Subject to ‘winners curse’
• Timing of the transaction vs valuation date of the target

Question 11

Reminder: study pre-/post IFRS multiples example on slide 36 multiples slide deck. This is a simplified version, so study in detail.

Answer 11

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Question 12

Give the derivation for P/E

Answer 12

PE = payout ratio / (rE - G)

Question 13

Give the derivation for EV/EBITA

Answer 13

EV/EBITA = (1-Tc)*(1-(G/RONIC)) / WACC - G

Question 14

Give the derivation for M/B ratio

Answer 14

M/B = ROE * payout ratio / (rE - G)

Question 15

What does it mean when the M/B ratio is below 1?

Answer 15

It means that the return you generate is below your cost of capital.

Question 16

What’s the disadvantage of PEG ratio?

Answer 16

PEG = PE ratio / EPS growth
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PEG ratio implies a linear relationship between PE ratio and growth, but this is actually exponential. And also, if a company has a growth rate of 0%, you would wrongly apply a value of 0 to this company.