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Standardized Values and Multiples
To compare the values of “similar” assets in the market, we need to standardize
the values in some way. They can be standardized relative to the earnings they generate,
to the book value or replacement value of the assets themselves, or to the revenues that
they generate. We discuss each method next.

1. Earnings Multiples
One of the more intuitive ways to think of the value of any asset is as a multiple
of the earnings it generates. When buying a stock, it is common to look at the price paid
as a multiple of the earnings per share generated by the company. This price/earnings
ratio can be estimated using current earnings per share, which is called a trailing PE, or
an expected earnings per share in the next year, called a forward PE. When buying a



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business, as opposed to just the equity in the business, it is common to examine the value
of the firm as a multiple of the operating income or the earnings before interest, taxes,
depreciation and amortization (EBITDA). While, as a buyer of the equity or the firm, a
lower multiple is better than a higher one, these multiples will be affected by the growth
potential and risk of the business being acquired.

2. Book Value or Replacement Value Multiples
While markets provide one estimate of the value of a business, accountants often
provide a very different estimate of the same business. The accounting estimate of book
value is determined by accounting rules and is heavily influenced by the original price
paid for the asset and any accounting adjustments (such as depreciation) made since.
Investors often look at the relationship between the price they pay for a stock and the
book value of equity (or net worth) as a measure of how over- or undervalued a stock is;
the price/book value ratio that emerges can vary widely across industries, depending
again upon the growth potential and the quality of the investments in each. When valuing
businesses, we estimate this ratio using the value of the firm and the book value of all
assets (rather than just the equity). For those who believe that book value is not a good
measure of the true value of the assets, an alternative is to use the replacement cost of the
assets; the ratio of the value of the firm to replacement cost is called37.

3. Revenue Multiples
Both earnings and book value are accounting measures and are determined by
accounting rules and principles. An alternative approach, which is far less affected by
these factors, is to use the ratio of the value of an asset to the revenues it generates. For
equity investors, this ratio is the price/sales ratio (PS), where the market value per share
is divided by the revenues generated per share. For firm value, this ratio can be modified
as the value/sales ratio (VS), where the numerator becomes the total value of the firm.
This ratio, again, varies widely across sectors, largely as a function of the profit margins
in each. The advantage of using revenue multiples, however, is that it becomes far easier




37 See Chung and Pruitt for a simple approximation of Tobin's Q.


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to compare firms in different markets, with different accounting systems at work, than it
is to compare earnings or book value multiples.

Determinants of Multiples
One reason commonly given for the use of these multiples to value equity and
firms is that they require far fewer assumptions than does discounted cash flow valuation.
We believe this is a misconception. The difference between discounted cash flow
valuation and relative valuation is that the assumptions we make are explicit in the former
and remain implicit in the latter. It is important that we know what the variables are that
cause multiples to change, since these are the variables we have to control for when
comparing these multiples across firms.
To look under the hood, so to speak, of equity and firm value multiples, we will
go back to fairly simple discounted cash flow models for equity and firm value and use
them to derive our multiples. Thus, the simplest discounted cash flow model for equity,
which is a stable growth dividend discount model, would suggest that the value of equity
is:

DPS1
Value of Equity = P0 =
ke ! gn
where DPS1 is the expected dividend in the next year, ke is the cost of equity and gn is the
expected stable growth rate. Dividing both sides by the earnings, we obtain the
discounted cash flow equation specifying the PE ratio for a stable growth firm:

P0 Payout Ratio * (1 + gn )
= PE =
EPS0 k e -g n
Dividing both sides by the book value of equity, we can estimate the price/book value
ratio for a stable growth firm:

P0 ROE * Payout Ratio *(1 + g n )
= PBV =
BV0 k -g e n

where ROE is the return on equity. Dividing by the Sales per share, the price/sales ratio
for a stable growth firm can be estimated as a function of its profit margin, payout ratio,
profit margin, and expected growth.


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P0 Net Profit Margin * Payout Ratio * (1 + g n )
= PS =
Sales 0 k -g
e n

We can do a similar analysis from the perspective of firm valuation38. The value
of a firm in stable growth can be written as:
!

FCFF1
Value of Firm = V0 =
kc ! g n

Dividing both sides by the expected free cash flow to the firm yields the Value/FCFF
multiple for a stable growth firm:

V0 1
=
FCFF1 k c ! gn
Since the free cash flow the firm is the after-tax operating income netted against
the net capital expenditures and working capital needs of the firm, the multiples of EBIT,
after-tax EBIT and EBITDA can also be estimated similarly. The value/EBITDA
multiple, for instance, can be written as follows:
Value (1- t) Depr (t)/EBITDA CEx/EBITDA ! Working Capital/EBITDA
= + - -
EBITDA kc - g kc - g kc - g kc - g
The point of this analysis is not to suggest that we go back to using discounted
cash flow valuation but to understand the variables that may cause these multiples to vary
across firms in the same sector. If we ignore these variables, we might conclude that a
stock with a PE of 8 is cheaper than one with a PE of 12, when the true reason may be
that the latter has higher expected growth or we might decide that a stock with a P/BV
ratio of 0.7 is cheaper than one with a P/BV ratio of 1.5, when the true reason may be that
the latter has a much higher return on equity. Table 12.7 lists the multiples that are widely
used and the variables that determine each; the variable that, in our view, is the most
significant determinant is highlighted for each multiple. This variable is what we would
call the companion variable for this multiple, i.e., the one variable we need to know in
order to use this multiple to find under or over valued assets.



38 In practice, cash and marketable securities are subtracted from firm value to arrive at what is called
enterprise value. All the multiples in the following section can be written in terms of enterprise value, and
the determinants remain unchanged.


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Table 12.7: Multiples and Companion Variables (in italics)
Multiple Determining Variables
Price/Earnings Ratio Growth, Payout, Risk
Price/Book Value Ratio Growth, Payout, Risk, ROE
Price/Sales Ratio Growth, Payout, Risk, Net Margin
Value/EBIT Growth, Net Capital Expenditure needs, Leverage, Risk
Value/EBIT (1-t)
Value/EBITDA
Value/Sales Growth, Net Capital Expenditure needs, Leverage, Risk,
Operating Margin
Value/Book Capital Growth, Leverage, Risk and ROC

eqmult.xls: This spreadsheet allows you to estimate the equity multiples for a firm,
given its fundamentals.

firmmult.xls: This spreadsheet allows you to estimate the firm value multiples for a
firm, given its fundamentals.

The Use of Comparable Firms
When we use multiples, we tend to use them in conjunction with “comparable”
firms to determine the value of a firm or its equity. This analysis begins with two choices
- the multiple that will be used in the analysis and the group of firms that will comprise
the comparable firms. The multiple is computed for each of the comparable firms, and the
average is computed. To evaluate an individual firm, we then compare its multiple to the
average computed; if it is significantly different, we make a subjective judgment about
whether the firm™s individual characteristics (growth, risk or cash flows) may explain the
difference. Thus, a firm may have a PE ratio of 22 in a sector where the average PE is
only 15, but the analyst may conclude that this difference can be justified because the
firm has higher growth potential than the average firm in the industry. If, in the analysts™
judgment, the difference on the multiple cannot be explained by the variables listed in
Table 12.7, the firm will be viewed as over valued (if its multiple is higher than the
average) or undervalued (if its multiple is lower than the average). Choosing comparable
firms, and adequately controlling for differences across these comparable firms, then


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become critical steps in this process. In this section, we will consider both these
decisions.

1. Choosing Comparables
The first step in relative valuation is usually the selection of comparable firms. A
comparable firm is one with cash flows, growth potential, and risk similar to the firm
being valued. It would be ideal if we could value a firm by looking at how an exactly
identical firm - in terms of risk, growth and cash flows - is priced. In most analyses,
however, analysts define comparable firms to be other firms in the firm™s business or
businesses. If there are enough firms in the industry to allow for it, this list is pruned
further using other criteria; for instance, only firms of similar size may be considered.
The implicit assumption being made here is that firms in the same sector have similar
risk, growth, and cash flow profiles and therefore can be compared with much more
legitimacy.
This approach becomes more difficult to apply when there are relatively few firms
in a sector. In most markets outside the United States, the number of publicly traded
firms in a particular sector, especially if it is defined narrowly, is small. It is also difficult
to find comparable firms if differences in risk, growth and cash flow profiles across firms
within a sector are large. Thus, there may be hundreds of computer software companies
listed in the United States, but the differences across these firms are also large. The
tradeoff is therefore a simple one. Defining a industry more broadly increases the number
of comparable firms, but it also results in a more diverse group.

2. Controlling for Differences across Firms
In Table 12.7, we listed the variables that determined each multiple. Since it is
impossible to find firms identical to the one being valued, we have to find ways of
controlling for differences across firms on these variables. The process of controlling for
the variables can range from very simple approaches, which modify the multiples to take
into account differences on one key variable, to more complex approaches that allow for
differences on more than one variable.




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a. Simple Adjustments
Let us start with the simple approaches. In this case, we modify the multiple to
take into account the most important variable determining it. Thus, the PE ratio is divided
by the expected growth rate in EPS for a company to determine a growth-adjusted PE
ratio or the PEG ratio. Similarly, the PBV ratio is divided by the ROE to find a Value
Ratio, and the price sales ratio is divided by the net margin. These modified ratios are
then compared across companies in a sector. The implicit assumption we make is that
these firms are comparable on all the other measures of value, besides the one being
controlled for.

Illustration 12.14: Comparing PE ratios and growth rates across firms: Entertainment
companies
To value Disney, we look at the PE ratios and expected growth rates in EPS over
the next 5 years, based on consensus estimates from analysts, for all entertainment
companies where data is available on PE ratios and analyst estimates of expected growth
in earnings over the next 5 years. Table 12.8 lists the firms and PE ratios.
Table 12.8: Entertainment firms “ PE Ratios and Growth Rates “ 2004
Ticker Expected
Symbol Growth Rate
Company Name PE PEG
Point 360 PTSX 10.62 5.00% 2.12
Fox Entmt Group Inc FOX 22.03 14.46% 1.52
Belo Corp. 'A' BLC 25.65 16.00% 1.60
Hearst-Argyle Television Inc HTV 26.72 12.90% 2.07
Journal Communications Inc. JRN 27.94 10.00% 2.79
Saga Communic. 'A' SGA 28.42 19.00% 1.50
Viacom Inc. 'B' VIA/B 29.38 13.50% 2.18
Pixar PIXR 29.80 16.50% 1.81
Disney (Walt) DIS 29.87 12.00% 2.49
Westwood One WON 32.59 19.50% 1.67
World Wrestling Ent. WWE 33.52 20.00% 1.68
Cox Radio 'A' Inc CXR 33.76 18.70% 1.81
Beasley Broadcast Group Inc BBGI 34.06 15.23% 2.24
Entercom Comm. Corp ETM 36.11 15.43% 2.34
Liberty Corp. LC 37.54 19.50% 1.92
Ballantyne of Omaha Inc BTNE 55.17 17.10% 3.23
Regent Communications Inc RGCI 57.84 22.67% 2.55
Emmis Communications EMMS 74.89 16.50% 4.54
Cumulus Media Inc CMLS 94.35 23.30% 4.05


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Univision Communic. UVN 122.76 24.50% 5.01
Salem Communications Corp SALM 145.67 28.75% 5.07
Average for sector 47.08 17.17% 2.74
Source: Value Line
This simple view of multiples leads us to conclude that Disney should trade at 47.08

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