1. Appropriate Multiple
Now, let's talk about some of the most common multiples. While there are
many other multiples, these are the most common in practice.
Let's discuss the pros and cons of each.
Enterprise value to revenue. This Multiple is more useful for a younger
company that hasn't reached profitability yet due to its age.
The drawback is that using revenue doesn't take into account the company's
costs, it's possible the young company may never reach profitability, thus
making it a poor investment. Revenue is an incomplete measure of performance,
given its lack of focus on profitability and cash flow.
Revenue as a performance measure and basis for evaluation should be a last
resort if other more relevant profit measures are unavailable or unreliable.
Enterprise value to EBITDA. It's a very common multiple and used quite a
bit in investment banking and private equity. This multiple is an improvement
over enterprise value to revenue, as it does take into account a measure
of profitability, it's mostly applicable to industries with a large amount
of long term assets, since we add back depreciation and amortization.
However, EBITDA is not the bottom line that net income is,
and often times companies will add back other expenses
when they report EBITDA. Also, EBITDA does not take into account any reinvestment
in the business. For example, you see how this multiple is mostly applicable
to industries with a large amount of long term assets,
however, the company must re invest in long term assets to maintain profitability
and productivity. EBITDA does not directly factor in reinvestment. Of course,
neither does enterprise value to revenue. An occasional adjustment to the
multiple that you might see is enterprise value
with EBITDA minus capex in the denominator, which does take into account
reinvestment. The price to earnings or P/E multiple.
When thinking about publicly traded companies, this is probably the most
common multiple you will encounter. The numerator is a company's share price
while the denominator is earnings per share. Alternatively, it can be calculated
by taking the market cap and dividing by net income.
This is most suitable for public mature companies.
The drawback is that the denominator is based on accrual accounting calculations.
Accrual accounting requires quite a few assumptions, and because of this,
companies can manipulate in their income the price to book multiple.
This multiple is probably the least common of the four we are discussing,
however, it or a version of it, is used quite a lot to
value financial service firms like banks. It could be calculated by taking
the market cap and dividing by the book value of shareholders equity.
The reason why this is used to evaluate banks is because a bank's
balance sheet is more reflective of the market value of assets and liabilities
compared to a non bank. Banks use something called mark to market accounting.
So the bank's assets and liabilities are usually pretty close to their market
value, although there are some exceptions. Non banks rely more on historical
cost accounting, so the assets and the liabilities may not be anywhere close
to their current market value. The drawback to, price to book is that
it has limited usefulness for non banks. Finally, there are also industry
specific multiples. However, industry specific multiples are outside the
scope of this course.
2. Let's practice!