Market Valuation Multiples

Question 1

What is Book value per share?

Answer 1

Book value per share is the amount of net assets attributable to the common shareholders per share outstanding:

= (Total equity - Liquidation value of preferred equity) /
Common shares outstanding

When preferred stock is cumulative and in arrears or participating, liquidation value will exceed the carrying amount of the preferred stock

Book value per share is ordinarily based on historical cost expressed in nominal dollars. It may be misleading because book values ordinarily differ materially from fair market values

Market value is what a share sells for on the open market. Book value may be materially higher or lower than market value

Question 2

What is Market/Book ratio?

Answer 2

It measures how much an investor must spend to “own” a dollar of net assets:

= Market price per share / Book value per share

Note: A high market/book ratio reflects the stock market’s positive assessment of the firm’s asset management

Question 3

What is Price/Earning ratio?

Answer 3

It measures how much an investor must spend to “buy” a dollar of earnings:

= Market price per share / Diluted earnings per share (or EPS or NI per share)

Note: Net income per share = EPS

A high price/earnings ratio reflects the stock market’s positive assessment of the firm’s earnings quality and persistence

Question 4

What is Price/EBITDA ratio?

Answer 4

It measures how much an investor must spend to “buy” a dollar of EBITDA

= Market price per share / EBITDA

A high price/EBITDA ratio reflects the stock market’s positive assessment of the firm’s generation of profits through ongoing operations

Question 5

What are the advantages to using EBITDA as a measure of performance?

Answer 5

Advantages of using EBITDA as a performance measure include:

1. Operational comparability - comparing a broader set of companies across industries
2. Proxy for cash flows

Note: The disadvantages outweigh the advantages

Question 6

What are the disadvantages of using EBITDA as a measure of performance?

Answer 6

Disadvantages of EBITDA:

1. Overstates income - EBITDA distorts reality. From a stockholder’s standpoint, investors are most concerned with the level of income and cash flow available after all expenses (including interest expense, depreciation expense and income tax expense)
2. Neglects working capital requirements - EBITDA may actually be a decent proxy for cash flows for many companies; however, this profit measure does NOT account for the working capital needs of a business

For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e. inventories, receivables, payables) are tabulated

3. Not effective for valuation - Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interest. However, companies with debt do deserve lower valuations compared to their debt-free counterparts

Question 7

What is Price-sales ratio?

Answer 7

Price-sales ratio is preferred by some analysts over profit ratios:

= Market price per share / Sales per share

Analysts who use the price-sales ratio believe that strong sales are the basic ingredient of profits and that sales are the item on the financial statements least subject to manipulation