Introduction to Equity Valuations (PE Ratios)

Introduction to Equity Valuations (PE Ratios)

Sarah Martin

30 years: Corporate Valuations

In this video in the series on corporate valuations, Sarah introduces enterprise value multiples and first covers the background to multiple valuations and then walks us through the process of carrying out a multiple valuation.

In this video in the series on corporate valuations, Sarah introduces enterprise value multiples and first covers the background to multiple valuations and then walks us through the process of carrying out a multiple valuation.

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Introduction to Equity Valuations (PE Ratios)

6 mins 47 secs

Overview

A multiple valuation simply involves multiplying a company’s financial variable, such as EBITDA or net profit by a corresponding multiple or ratio observed in a peer group of similar firms. The main benefit of a multiple valuation is that it allows us to estimate valuations without having to go through the rigour of a DCF calculation. It is important to understand the the background to it along with the execution.

Key learning objectives:

  • Understand what are multiple valuations and the background to them

  • Understand the mechanics of multiple valuations

  • Comprehend why multiples vary between firms and sectors

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Summary

What are enterprise valuation multiples and where are they used?

Taking a metric such as a firm’s forecast EBITDA and multiplying this variable by the average or median EBITDA multiple at which a peer group of comparable firms trades gives us an estimate of the EV of a firm. This estimate is produced by using only two variables and hence is straightforward.

Multiples can be used to value a private company or to test whether an existing value is high or low relative to the chosen peer group. It is a relative value method – valuing one firm, based on the current valuation of comparable firms. 

How do multiple valuations work? 

  • Select a peer group which has current valuations. These valuations are usually a share price but an M&A valuation could also work. Ideally, peer group members have the same key characteristics as the firm you are valuing. It is usually better to have a small peer group of reasonably comparable companies, rather than a large peer group where the constituents might technically be in the same sector but in practice have very different business profiles and return outlooks.

  • Calculate the enterprise value of the peer group companies. For listed firms, we normally take the market capitalisation and add on net debt and equivalents to reach enterprise value. It is important to note that valuation experts often work out net debt differently from each other.

  • Calculate EBITDA for the firm being valued and all the peer group members. As EBITDA is undefined by IFRS and US GAAP, there are differing definitions. Underlying EBITDA should be used, not reported EBITDA. Normally, it is preferred to use forecast numbers and if the peer group constituents have different fiscal year ends, it is better to use next 12-month forecasts.

  • Calculate the EV/EBITDA multiple for each firm. Usually use 3 multiples for each firm -  a historic multiple, this year’s multiple and a forecast multiple. EV comes from the market capitalisation, which changes daily with the share price. Hence, the multiples will change every day as the share prices change every day.

  • Calculate the average or median EBITDA multiple for your peer group and apply this to the EBITDAs of the firm you are valuing. Using the 2023 forecast multiple for the peer group and multiplying this with the forecast 2023 EBITDA for the firm you are valuing would provide a valuation today for the firm. This is because the peer group average multiple was based on today’s share prices of the peer group. 

Why do multiples differ between firms?

Financial factors:

  1. Different growth outlooks – high-growth firms usually have higher multiples
  2. Risk outlook – lower-risk firms, with lower WACC, usually have higher multiples
  3. Outlook for the return after tax on capital employed, also known as the return on invested capital

Non-financial factors – Some of the non-financial factors include Poor corporate governance, ineffective management, adverse regulatory changes, a poor track record of M&A, lack of value creation, worsening event risks and geo-political risks, technological threats, a poor innovation record and high customer concentration. A firm may also be impacted by a low free float (only a small percentage of the shares are listed, its trading multiple can be affected)

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Sarah Martin

Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

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