Business Analysis and

Valuation
Dr. Aprajita Pandey
BITS Pilani Department of Economics and Finance
Pilani Campus
 BITS Pilani
Pilani Campus

Multiples in Firm Valuation

 Introduction

• Valuation methods that use multiples are based on identifying companies that are
similar to the one we want to value. These similar companies are called “comparable
firms” or comparables.
• Multiples valuation is based on the assumption that markets will price equivalent
assets in a similar way and therefore the value of a company can be derived by
calculating the market value of comparable firms. A comparable firm is a firm that
operates in the same industry and has similar key financial parameters (i.e; growth
and profitability) as the firm we want to value.

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 Introduction

• In order to be able to compare companies, we use “multiples” in which the value of a

company (e.g., its share price or total enterprise value) is referenced to some
financial item (e.g., its earnings, EBITDA or revenue).
• Commonly used multiples include the price-to-earnings ratio (P/E ratio or PER), the
ratio of enterprise value to EBITDA (EV/EBITDA or EBITDA multiple) and the
ratio of enterprise value to sales.
• In summary, to determine the value of firm XYZ, we can use the multiple of its
comparable firm or set of comparable firms, as follows:
• (Value of firm XYZ) = (Multiple of XYZ’s comparable firms) * (Firm-specific
variable of firm XYZ)

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 Where Can we Use Relative Valuation

• To Value Nontraded Private Companies.

• To Value Divisions of Traded Companies.
• To see how a listed company is valued relative to its peer.
• To value a transaction, such as an M&A deal, relative to other transactions involving
its peers.

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 Steps in Comparable Analysis

• Selection of comparable companies

• Identifying required financial information
• Determining key financial statistics, ratios, and multiples.
• Benchmarking the comparable companies.
• Determining valuation.

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Consider the valuation of a home with 3,581 square feet of floor space, located in Mc
Gregor, Texas (five east of former president George W. Bush’s ranch in Crawford
Texas). The house is only one-year-old, is situated on an oversized lot, and has as
swimming pool. The owner has set an asking price of $385,000 but has indicated a
willingness to be flexible. Our problem is to estimate what the house should sell for,
given the information on two recent market transactions in the same neighborhood.

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The home is located in a popular area where recent sales have been recorded.
The subdivision in which the home sits is less than five years old, so all the
homes are of approximately the same age and condition. Two sales have
occurred in the immediate neighborhood over the previous six months.
Details on these sales are found below:
Comp 1 Comp 2
Sale price $330,000 $323,000
Square footage 3,556 4,413
Selling price/sqft. $92.90 $77.96
Time on the market 97 days 32 days

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Up to now, we have not taken into account two distinctive features of the house
we are valuing. Specifically, it is located on a lot that is somewhat larger than
the average lot in the subdivision, which may be worth $15,000 to $20,000
more than the average lot. In addition, the home has a new swimming pool,
which cost about $ 30,000

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How to price the stock of a firm using the P/E
Ratio
Example 1
• We want to find out whether firm XYZ's stock price of €30 per share is too high.
The earnings per share (EPS) of XYZ are €1.20. XYZ's best comparable firms are
ABC and DEF. which present stock prices of €20 and €40 per share and EPS of
€1.25 and €2.00, respectively. Is the stock price of firm XYZ (€30 per share)
overpriced?

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• Let us use the price-to-earnings ratio as the multiple. The P/E ratio of firm ABC is its
stock price divided by its EPS - that is, 20 / 1.25 = 16Equivalently, the P/E ratio of
firm DEF is 40 / 2.00 = 20. The average P/E ratio of both comparable firms is the
average of 16 and 20 Therefore, the multiple of XYZ's comparable firms is 18. The
implied value of the stock price of firm XYZ is the multiple of XYZ's comparable
firms (18) multiplied by the EPS of XYZ (€1.20) - that is, €21.60Hence, XYZ's
actual stock price of €30 looks high compared with the price obtained with a
multiples valuation using the P/E ratio with ABC and DEF as comparable firms.

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 Types of Multiples

• There are two main types of multiples depending on the reference on which they are
based: transaction multiples and trading multiples. Trading vs. Transaction Multiples
• Trading multiples are calculated using information about similar companies that are
traded on the stock market. Example 1 showed the use of trading multiples.
• Multiples are expressed relative to current or future performance.
• Transaction multiples are based on precedent merger and acquisition (M&A)
transactions in which the target company can be compared with the firm we want to
Value includes takeover premium, and multiples are expressed relative to the target
company's historical financials.

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 Example 2

• We want to acquire firm XYZ. Therefore, we need to estimate its value in order to
negotiate the acquisition. XYZ's EBITDA is €5 million and it has no debt. XYZ's
best comparable firms are ABC, DEF and GHI, which have been acquired recently
for a total value of €40 million, €60 million and €11 million, respectively. The
EBITDA of the three acquired firms are €8 million, €10 million and €2 million,
respectively. None of the companies has debt. What is the fair acquisition value for
XYZ?

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 Example 2

• Let us use the comparable transaction analysis to estimate a fair acquisition value for
XYZ. The EV/EBITDA ratio of firm ABC is its acquisition enterprise value (EV)
divided by its EBITDA - that is, 40/8 = 5. Equivalently, the EV/EBITDA of firm
DEF is 60/10 = 6 and the EV/EBITDA of firm GHI is 11/2 = 5.5. The average
EV/EBITDA ratio of the three comparable firms is the average of 5, 6 and 5.5 - that
is, 5.5Therefore, the average multiple of XYZ's comparable firms is 5.5. The
estimated value for XYZ is the mean multiple for comparable transactions (5.5)
multiplied by the target company's valuation variable (EBITDA) of XYZ (€5
million) - that is, €27.5 million.

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 Enterprise Value-Based Vs. Equity-Based
Multiples
• Enterprise value-based multiples are determined by the value of the whole company,
which consists of the market value of equity plus net debt (gross debt minus cash).
This multiple is not affected by financial leverage (debt levels) as enterprise value
includes the value of debt, and EBITDA is available to all investors (debt and
equity) as it excludes interest payments on debt. The EV/EBITDA ratio is not
influenced by capital structures. The ratio is not affected by the effect of noncash
expenses such as depreciation and amortization.

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Effect of capital structure on enterprise value
Scenario 1: Issuance of New Debt Actual Adjustment Proforma

Equity Value 1550 1550

Plus: Total Debt 650 250 900
Plus: Preferred stock 150 150
Plus: Non-controlling stake 35 35
Less: Cash and Cash equivalents 235 250 485
Enterprise Value 2150 2150

Scenario 1: Issuance of Equity to Repay debt Actual Adjustment Proforma

Equity Value 1550 250 1800

Plus: Total Debt 650 250 400
Plus: Preferred stock 150 150
Plus: Non-controlling stake 35 35
Less: Cash and Cash equivalents 235 235
Enterprise Value 2150 2150

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• Another advantage is that there are far fewer firms with negative EBITDA than there
are firms with negative earnings per share. Unlike P/E ratios, EV/EBITDA ratios can
be used to compare a wide variety of companies. EV multiple valuation will need to
be stripped out of net debt to derive the equity value of the target company.

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 Example 3

• The stock price of XYZ is $30 per share. We want to evaluate the stock of XYZ
relative to that of its peers. XYZ’s best comparable firms are ABC and DEF, which
present stock prices of $14 and $18 respectively. XYZ has five million shares
outstanding, ABC has 21 million, and DEF has six million. XYZ’s cash is $9 million.
ABC’s cash is $55 million and DEF’s cash is $16 million. XYZ’s debt ( for the most
recent quarter) is $7.4 million, ABC’s debt is $32 million and DEF’S debt is $12.5
million. Their EBITDA figures (12 months) are $14.5 million for XYZ, $28.5
million for ABC and $20 million for DEF. How does the stock price of XYZ ($30)
look relative to that of its peers?

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• Let us calculate the market capitalization (i.e., the market value of equity) by
multiplying the stock price by the number of shares outstanding- that is, $14*21
million = $294 million for firm ABC, and $18 * 6 million = $108 million for firm
DEF.
• Now , let us calculate ABC’s and DEF’S enterprise value as follows:
• EV = Market capitalization + Debt – Cash
• Therefore, the EV of ABC is $294 M + $32 M-$55M = $271 M, Equivalently, the
EV of DEF is: $108 M + $12.5 M - $16M = $104.5 M
• Let us calculate the EV/EBITDA multiples for ABC and DEF:
• ABC’S EV/EBITDA: $271M/$28.5M = 9.51
• DEF’s EV/EBITDA: $104.5 M/$20M = 5.23

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• The average of the EBITDA multiples of the two comparable firms is 7.37. Hence,
the EV of XYZ is $14,500,000 * 7.37 = $106,819,846.
• Now, let us calculate XYZ’s market capitalization as follows:
• Market capitalization = EV – Debt + Cash
• Therefore, the market capitalization of XYZ is $106,819,846 - $7,400,000 +
$9,000,000 = $108,419,846. Now let us divide this market capitalization by the
number of shares (five million) to find the stock price – that is, $22. We can see that
XYZ is trading at a higher price ($30) compared with the price that we obtain using
ABC and DEF as comparable firms ($22), so XYZ is relatively overvalued.

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 Equity-based Multiples

• Equity based multiples are based on either the market value of equity, calculated by
multiplying the share price by the number of shares, or on the value of a single share.
It is the simplest multiple, and the price-to-earnings ratio is the most commonly
used. There are two major drawbacks: some reference parameters (e.g., earnings or
net income) are vulnerable to changing accounting standards, and net income is
affected by capital structure. This makes it difficult to use P/E ratios to compare
companies with different leverage ratios. Previous example showed the use of
equity-based multiples.

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 Identifying Comparable Firms

• The best way to determine and identify a suitable combination of companies is to

rely on a sample from the target’s own industry. These are the two basic steps for
identifying comparables:
• Defining a sample of comparable firms
• Use a standard industrial classification (e.g., SIC or GICS) to get an extensive list of industry peers.
• Narrow down the sample by testing for business focus and size (e.g., market capitalization and sales).
• Test crucial variables such as growth, profitability and cash flow potential for comparison.
• Compare your list of comparable firms to the lists in analysts reports, industry publications and credit rating agencies’
reports.
• Take a further look beyond industry boundaries to gather a list of comparables based on similar growth, risk, and
performance patterns, both expected and historical.
• Cross check your sample by:
• Looking at company publications. It may list its peer group in its annual report
• Examining broker reports and reviewing their suggestions for a list of competitors.
• Checking out the list of companies in various industry indices.

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Identifying Comparable Firms

• Looking at other factors:

• Business mix: different products can increase at different rates and/or have very distinct profitability levels, which is also a
measure of risk.
• Sales, assets, employees: these tell us about the size of the company.
• Capital expenditure: the depth of investment in the business is a driver of future profit growth.
• Geographical sales mix: this shows us whether we are dealing with developed or growth markets and additionally it is a
risk indicator.
• Expected ROI, profit margin, cash flow pattern: these represent a firm’s ability to generate profit in the future and its
expected profitability. They are also a key driver in DCF valuation as well.
• Cost of capital: this can indicate risk associated with the respective business.

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 Historical vs. Forward-Looking Multiples

• Trading multiples are usually based on current or forward-looking multiples. This

forward-looking approach is consistent with discounted cash flow valuations.
Moreover, the empirical evidence shows that forward-looking multiples are more
accurate predictors than historical multiples.
• If there are no reliable forecasts available, then we must rely on historical data. We
should make sure we use the latest data possible for the most recent four quarters,
not the most recent fiscal year.
• Transaction multiples are based on historical multiples, usually on the 12 months
prior to the transaction date.

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 Selection of Multiples

• There is a long list of variables to be used as multiples. The most common multiples
are the following:
• Price/earnings
• Price/book value of equity
• Price/operating cash flow
• EV/sales
• EV/EBITDA
• EV/EBIT
• There are also sector-specific multiples, which provide useful adaptations of
commonly used multiples for specific industries.

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 Industry- specific multiples

• Power Sector: Enterprise value by Megawatt (EV/MW)

• Entertainment & Media: EV/Per screen
• Pharma: New drug approvals, patents
• Print Media: EV/Subscriber
• Cement: EV/Ton

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 Determinants of Multiples

• When using valuation multiples in finance, it is essential to understand the

underlying determinants that influence these multiples. The determinants help
explain why certain firms or industries might have higher or lower multiples.

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 Price-to-Earnings (P/E) Ratio

Determinants:
– Growth Rate of Earnings: Firms with higher expected earnings growth
generally have higher P/E ratios.
– Risk (Cost of Equity): A higher risk or cost of equity (due to market volatility or
company-specific factors) usually results in a lower P/E ratio.
– Profitability (Return on Equity - ROE): Companies with higher ROE may
command higher P/E ratios.
– Dividend Payout Ratio: A higher dividend payout ratio can increase the P/E
ratio, as it implies more cash returned to shareholders.

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 Price-to-Book (P/B) Ratio

Determinants:
– ROE Relative to Cost of Equity: Companies that have an ROE higher than their
cost of equity tend to have a higher P/B ratio.
– Growth Opportunities: Firms with significant growth prospects often have
higher P/B ratios.
– Asset Intensity: Capital-intensive industries may have lower P/B ratios because
of higher tangible assets on the balance sheet.
– Risk and Stability: Stable companies or those with strong brand recognition and
intangible assets tend to have higher P/B ratios.

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 Price-to-Sales (P/S) Ratio

Determinants:
– Profit Margins: Companies with higher net profit margins typically have higher
P/S ratios.
– Revenue Growth: Firms expecting higher revenue growth may have higher P/S
ratios.
– Industry Characteristics: Certain sectors, like technology, may naturally have
higher P/S ratios due to high growth expectations.

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 EV/EBITDA (Enterprise Value-to-EBITDA)

Determinants:
– Capital Structure: EV/EBITDA is independent of the capital structure, making it useful for comparing
companies with different debt levels.
– EBITDA Margins: Companies with higher margins often have higher EV/EBITDA multiples.
– Growth Prospects: Firms with strong EBITDA growth expectations command higher multiples.
– Risk Factors: Lower risk or more stable cash flow firms may exhibit higher EV/EBITDA multiples.
• Operating Efficiency: Companies with efficient operations and higher EBITDA margins typically
have higher EV/EBITDA multiples.
• Industry Factors: Capital-intensive industries may have lower EV/EBITDA ratios compared to industries
with lower fixed costs.

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 EV/EBIT (Enterprise Value-to-EBIT)

Determinants:.
– Growth and Stability: High growth and stable cash flow companies typically have higher EV/EBIT multiples.
– Operating Efficiency: Firms with efficient operations and cost management may exhibit higher multiples.

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 How to Determine These Determinants??

• Analyze Industry Trends: Certain industries naturally have different growth rates,
risk profiles, and capital structures, which impact their typical multiples.
• Examine Company Financials: Factors like profitability, revenue growth, and cost
structure are key in determining multiples.
• Consider Macro and Microeconomic Conditions: Economic trends such as interest
rates, inflation, and political stability can influence risk and growth prospects,
impacting multiples.
• Benchmark Against Peers: Comparing a company’s multiples to its peers can
reveal why it might be valued differently, providing insight into its specific
determinants.

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 How to Determine These Determinants??

• Regression Analysis: Analysts can use historical data to run regression models to see
which variables (e.g., growth rate, ROE, risk metrics) significantly influence the
multiple in question.
• Comparative Analysis: By analyzing comparable companies within the same
industry, analysts can observe how differences in profitability, growth, or risk factors
impact their multiples.
• Theoretical Models: Financial models like the Gordon Growth Model or discounted
cash flow (DCF) can be used to understand the theoretical underpinnings of
multiples and identify key drivers.
• Industry Reports: Using industry benchmarks and reports helps identify typical
ranges and key value drivers for multiples within a sector.

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