In recent posts we spoke about companies valuation by the Discount Cash Flow method (DCF), where we could obtain the intrinsic value of a company by means of the calculation of the present value of the future expected cash flows. The other way of valuing a company is with the Multiples approach, which in most cases is complementary of the DCF.
Multiples Analysis assumes the idea that similar companies (of the same sector, industry, etc with similar characteristics) show a similar value compared to their financial numbers (earnings, cash flows, etc). For example, we could assume that companies in the same sector, with similar debt, similar size and similar earnings should show similar fundamental ratios (multiples) like price to earnings, Enterprise Value to EBITDA or others.
We refer to Multiples as the ratios formed from the division of the market value of an asset by an item of the financial statement of the asset. Calculating the values of these Multiples, we could compare them between assets with similar business and financial situation, and obtain a value of the company in terms of equity or enterprise value just using some of the items of the financial statements.
Types of Multiples
We can classify the Multiples between Enterprise Value (EV) multiples (that value the whole company) and Equity multiples, which are ratios that relate the company’s share price and items of the performance of the company, like earnings, sales, cash flows, etc. Even though Equity multiples are widely used by investors because of being easier to obtain, EV multiples gather more information of the companies and are more comparable between companies.
EV multiples commonly used are EV/EBIT or EV/EBITDA. Equity multiples used frequently are Price to Earnings, Price to free cash flow or Price to Sales.
The same as in Discount Cash Flow method, the main difficulty of Valuation Multiples is to forecast the evolution of the different items of the financial statements in order to give valuations of the company in the future. In order to calculate the multiple of a company we can consider the values of some similar assets and calculate their ratio/multiple we consider more appropriate. We can aggregate these ratios to obtain a possible Multiple for the target company we try to value: we could use the median of the companies ratio or some high or low percentiles in order to define a range in which the target company could be.
Once we define a plausible multiple of the company, we should propose the future evolution of the financial statement items, by defining revenues growth, EBIT Margin or Tax rate. There are those who use historical figures of the same company to approximate these future growth items by regression or other statistical methods.
In the table below we can see the annual EV to EBITDA and the Prices to Earnings of some assets from the Semiconductor sector corresponding to the second quarter of 2022:
As you can observe, some of the assets present very different figures in their ratios; NVIDIA and Advanced Micro Devices are overvalued against the rest of the companies. Let’s look up some firms data to obtain the valuation of the different assets for a different Multiple:
If we assume that the median of the ratios are fair figures (15.5 and 16.9 respectively) for the companies evaluated, we could estimate the value of each company at September 15th:
- Multiplying by EBIT, subtracting the Net Debt and dividing by the number of shares in the case of EV to EBIT.
- Multiplying by Earnings (and subtracting Net Debt if it is negative) and Dividing by the number of Shares if using Price to Earnings
Likewise, if we want to value the company one year later from EV/EBIT, maintaining the same Multiple figure 15.5, we should choose the revenues growth, propose an EBIT Margin (EBIT/Revenues) and establish the Net Debt. If we assume that the revenues will grow 10% and that the EBIT Margin is 30%, keeping the Net Debt and Diluted Shares unchanged, we would obtain the following valuation:
I hope you liked the post. If you use valuation multiples do not hesitate to sharing here your comments on how you approach this valuation or any other thoughts.