"Equity valuation using multiples" Liu, Jing, Doron Nissim, and Jacob Thomas

Question 1

What are multiples and how do they work?

Answer 1

Multiples are a simple valuation technique that is used widely in practice but there is very little empirical research on it.

Doesn’t use direct CF discounting, but relies on similar principles: value is an increasing function of future payoffs and a decreasing function of risk.

Question 2

Which measures are tested?

Answer 2

● Historical CF
● Historical accrual-based measures:
○ Sales
○ Earnings
○ BV of equity
● Forward-looking measures from analysts’ forecasts

Instead of equity, use enterprise value for sales and EBITDA multiples.

Question 3

Which measures perform the best relative to others?

Answer 3

Ranking order:
1. Forward earnings multiples perform best (even better if forecast horizon lengthens and if future earnings forecasted are aggregated)

2. Intrinsic value measures, based on equity and PV(future income) (use discounting), measurement error with extra variables
3. Historical earnings measures
4. CF measures and book value
5. Sales (its value is limited until matched with expenses)

Using enterprise value, rather than equity value, for sales and EBITDA further reduces performance.

Question 4

What is the absolute performance of the methods?

Answer 4

● Forward earnings measures describe actual stock prices reasonably well for a majority of firms
○ FE contain more value-relevant info than historical data, should be used as long as earnings forecasts are available
○ For 2-year out forecasted earnings, half the firms have absolute pricing errors <16%

● The dispersion of pricing errors increases substantially for multiples based on historical drivers (earnings and CFs), especially large for sales multiples

Question 5

What improves and what worsens the performance of the multiples?

Answer 5

IMPROVES when:
● Multiples computed with the harmonic mean (gives equal weight to each data point)
● Poorly-performing multiples are allowed having an intercept (can capture some OVB)

WORSENS when:
● All firms in the cross-section each year are used as comparable firms

● Relative performance is relatively UNCHANGED over time and across industries.

Question 6

What are 2 important findings that are contrary to popular beliefs?

Answer 6

Different industries are not associated with different “best multiples”.

Accruals improve the valuation properties of future cash flows (some CFs do not reflect value creation, accruals reflect judgements of future).