Trading multiples

The implied share price of the target company expresses the share price of the target company, if it would trade at its peers multiples.

Trading multiples are also known as: comps., comparable company analysis, peer group trading, peers multiples etc.

This part is about trading multiples. It contains two different sections: the first section focuses on trading multiples from a theoretical perspective and the last section focuses on trading multiples from an applied valuation perspective, hence this is an example of how the theory is applied to valuation.

The Trading multiples methodology is a comparison to the stock market pricing of comparable listed companies (“peers”) with similar characteristics (from an investor’s perspective).

The debt free price (EV) of each listed peer is compared to that peer’s earnings level (e.g. EBIT) in a given year (expected or realised), hence the “multiple” or ratio. Having determined a relevant multiple, such multiple can be multiplied by the relevant target object’s expected earnings to arrive at an indication of the EV of the target.

Trading multiples - theoretical section

Trading multiples

Trading multiples is a valuation method. It is very common an almost always included as a part of a complete valuation of any given company. Multiples can be particularly useful compared to other methods in an pre-IPO (Initial Public Offering - when a private company is listed) analysis. Normally there exist some very good benchmark companies that are listed, by applying this peer(s) stock market valuation to the IPO candidate, the result is a good indication of what value the public will attach to the IPO candidate once floated.

How trading multiples work

In peer group valuation the value of the target company depends on its forecasts compared to the estimated multiples of comparable companies. The relative valuation will be based on the company’s own forecasts, your own forecasts and analysts’ estimates

The fundamental assumption in multiple valuations is that the Value is proportional to an observable value driver (i.e. EBITDA etc.) with corrections

• Mt – the multiple at time t (e.g. the median) in the peer group
• Di,t – the value driver (e.g. EBITDA estimate) for company i at time t
• Ei,t – is the error estimate (EV multiples should take NIBD)

Multiples are a relative simple type of valuation since it is based on two variables (see previous equation). However when accurately applied, multiple valuation is everything but simple, it might be the most exhaustive of valuation models

Best practice when using trading multiples

Multiples are relatively easy to apply in valuation. However there are a number of potential pitfalls, therefore the following best practice should be applied when using multiple in valuation:

Trading multiples is a valuation method. It is very common an almost always included as a part of a complete valuation of any given company. Multiples can be particularly useful compared to other methods in an pre-IPO (Initial Public Offering - when a private company is listed) analysis. Normally there exist some very good benchmark companies that are listed, by applying this peer(s) stock market valuation to the IPO candidate, the result is a good indication of what value the public will attach to the IPO candidate once floated.

It is important not to base a multiple valuation on a single year’s estimates. Sales, EBITDA etc. are different between years. DCF and EVA catch this volatility but a one-year multiple doesn’t. Therefore a multiple valuation should always be based on estimates from multiple years.

According to best practices it is necessary to identify peers with the same business concept, accounting principles, growth, ROIC and financial and operational risk. Consequently it is necessary with an equally profound analysis as in the DCF valuation, but for each peer company. In applied valuation it is seldom possible to identify fully comparable peers, according to best practice; consequently the peer group selection is based on approximations. Peers operate within the same industry but do not necessarily have the same size and risk. Evidently the peer group valuation is not exact.

Pitfall of trading multiples

The peer group median/mean multiple depends on the market capitalization of the peer group companies. Therefore there is an implicit assumption about market efficiency when applying multiple valuation. This is a paradox since, assuming that the peer group companies are correctly priced the market is efficient and therefore the target company would also be correctly priced.Consequently peer group valuation is most valuable as a valuation method when valuating non-public companies, hence valuation of a non-public target based on its public peers. However multiple valuation of a public company provides insight concerning the relative valuation of the company.

Limitations to trading multiples:

• Trading multiples do not reflect a potential control premium - hence it does not reflect what a buyer will have to pay to acquire the company in an M&A process, but the trading value
• Trading multiples do not reflect a potential discount following and IPO
• Trading multiples normally use 1-3 years of forecasts to determine the whole value which is based on a going concern assumption until the end of time - the valuation is very sensitive to a few forecasts

Peer identification methodology

In multiple valuation identification of appropriate peers is a prerequisite. Peers should have the same business model, accounting principles, growth, ROIC and financial and operational risk. Consequently, to select the peer group, it is fundamental to understand the target company's business.

Normally the peer group will be based on companies from the same industry. Selecting the most appropriate peer group is not easy. The following sources are normally helpful in the peer group selecting process:

• The target company's management - they know their primary competitors. This is the best starting point.
• Normally the peer group is based on companies from within the same industry, hence browse through the companies within the same industry (use industry classification codes (SIC, NAICS etc.). Different data providers also provide their own industry classification (Hoovers, FactSet, CapitalIQ, Thomson Reuters, Bloomberg)
• Analyst research reports - when a public peer has been identified, additional peers can be found through analyst research reports
• Web site, annual and quarter reports, prospectus
• Table of content - covered companies - from relevant market research reports

Types of trading multiples

Broadly speaking valuation can be measured by EV and MV. EV includes all stakeholders where MV only includes common shareholders. This is very important to keep in mind when working with multiples. A multiple is a ratio, hence there is a numerator and a denominator. It is a prerequisite for the use of multiples that the numerator and denominator measures the same stakeholder (to all holders of capital). Hence, it is useless to compute a MV / EBITDA multiple. MV only reflects the equity holders whereas EBITDA not only reflects equity holders but also all other stakeholders (i.e. EBITDA is before any debt or interest is paid to debt holders). Therefore any equity value based multiples must be combined with a denominator that only reflects residual cash flows available to equity holder. Hence interest (debt), preferred dividends and minorities must be deducted.

Following the same logic, EV multiples must only be combined with a denominator that includes all stakeholders (i.e.: Sales, EBITDA, EBITA, EBIT, NOPLAT, FCFF).

Enterprise Value multiples

• Enterprise Value / Sales - This ratio is normally used as an approximate expression for valuing new companies with little or no earnings or for companies whose earnings are characterized by significant cyclicality. Since the ratio does not take differences in margins and capital intensity into account, it is mostly useful to companies within the same industry and with the same degree of vertical integration
• Enterprise Value / EBITDA - This ratio takes no differences in capital intensity into account. So it is not useful for comparing companies in different industries.
• Enterprise Value / EBITA - This ratio is one of the most usable enterprise value-based multiples. When comparing companies in different countries, it is recommended that differences in tax systems is taken into account
• Enterprise Value / EBIT - This ratio is one of the most usable enterprise value-based multiples. When comparing companies in different countries, it is recommended that differences in tax systems is taken into account
• Enterprise Value / NOPLAT - Very useful ratios. It represents a debt free operating P / E. It also eliminates the disadvantages are the same equation of companies in different tax systems, as is the case with other EV multiples
• Enterprise Value / FCFF - Non-leveraged P / E. Indicates the number of years it takes to return the investment

Equity Value multiples

• Price earnings ratio - P/E ratio - P/E is commonly used in connection with valuations. It is also an appropriate ratio in many cases because there are only small discrepancies between EPS and cash flow right

Enterprise Value multiples vs. Equity Value multiples (MV)

EV is measured on a debt free basis which MV is not. Subsequently EV based multiples are not affected by capital structure which MV multiples are. This makes EV multiples more easy to apply since companies can be compared irrespectively of capital structure.

Another important difference between EV and MV multiples is that the denominator in EV multiples is computed higher up in the income statement than the denominator in the MV multiples. This makes EV multiples much less sensitive to different tax systems, which is very important as a peer group very often includes companies from numerous tax regimes.

Trading multiples - applied section

EV multiples

From a theoretical perspective EV based multiples are the best multiples to use in valuation. EV multiples are also the most common multiples used in valuation. Let's imagine that we are going to assess the value of a trucking company using EV multiples. We apply the following EV multiples:

• Enterprise Value / Sales
• Enterprise Value / EBITDA
• Enterprise Value / EBIT

Initially we identify our peer universe by searching through industry classifications for trucking companies. We choose to focus on the Northern European public peers since our target company is active within this geography.

We exclude very small companies since multiples are based on forecasts provided by different analysts. Very small companies are often not covered by more than one or two analysts. Subsequently, the forecasts for small companies are less statistically strong. Large companies are frequently covered by more than 7-8 different analysts and therefore provide for a stronger and more up to date forecast. (The figure below indicates this issue, company no. 2 is very small and is not covered by any analysts, consequently it is not possible to derive any multiples from this company.

Numerator

Let's start with the numeratorEV. For each of the peer group companies we calculate the EV according to the below formula:

NIBD
(Net Interest Bearing Debt) = Debt* – cash and cash-equivalents*

Minorities
If a parent entity owns 60% (above 50%) of a subsidiary, shareholders that own the remaining 40% (below 50%) represents the minority interest. Hence minority interest refers to the portion of a subsidiary corporation's stock that is not owned by the parent corporation. Since EV encompasses the whole company and not only the shareholders, minority interest must be added to the enterprise value.

Normally minorities are included in the EV calculation, if this is not the case the denominator (EBITDA, EBIT, etc.) must be adjusted to exclude the portion that belongs to the minority holder.

The minorities can be measured either at fair value or as the proportionate share of net assets, both measurements are determined as at the acquisition date.

Associates
Associate company is reciprocate of minority interest. Hence if a company owns less than 50% of another company, this company is not a subsidiary but an associated company. An associated company is not consolidated into the parent's books. Associated company is reported as an assets end dividends from the ownership are reported in the income statement. Where a minority represents another entities stake in "your" assets, an associated company represents "your" stake in another company.

Normally associated companies are included in the EV calculation, if this is not the case the denominator (EBITDA, EBIT, etc.) must be adjusted to include the portion that originates from the associated companies (this is reported below/after EBIT, hence not by default included).

Preferred equity
Preferred stock (equity) is a special equity security that is senior (i.e. higher ranking) to common stock but are subordinate to bonds. Preferred equity that is not convertible into common equity should be treated as a financial liability (debt).

Since it is a claim on the company, however junior to bonds, preferred stock must be included in the EV calculation. Preferred stock is added to into EV calculation in the same way as debt.

Denominator

The denominator is the operational metrics/value driver. For each of the peer group companies the value driver is based on analysts' forecast. There exists a couple of data providers that gather analysts' forecasts, the most common providers are: Thomson Reuters I/B/E/S, Bloomberg and JCF (now part of FactSet - FactSet JCF). Larger companies are always covered by numerous analysts. Since each analyst provides forecast for Sales, EBITDA and EBIT it is necessary to use either the median or average forecast.

Hence, the denominator is not very hard to calculate since it is based on analysts' forecast. However, it is important to make sure that estimates used are not to old (old if the estimate was based on old outdated information that has been replaced by new information about the company - however, we don't think you should include estimates that are more than 100 days old)

Calendarised
Not all companies have the same financial calendar. Consequently, when applying analysts forecasts for next year’s EBITDA, next year might differ between companies, therefore it is important to calendarise estimates.

Further the forecasts are usually provided on a calendar year basis, however it is necessary to verify that this is the case, hence make sure all estimates are either based on calendar year or the fiscal year.

Imagine that company X's financial calendar ends as of ultimo September. Further, imagine that today is January 1, 2010 and we would like to find the EBITDA estimate for the next twelve months (NTM). In this case we would have to include analysts EBITDA 2010 estimate and add a fraction from EBITDA 2011 estimates corresponding to the October to December (2010) part of the analysts 2011 EBITDA estimate.

Adjustments
It is important that the estimates are normalized since the whole valuation is based on a single forecast. Therefore this forecast should be representative for the normalized level. Consequently, it is necessary to exclude extraordinary and non-recurring items.

Peer group alignment
It is important that the denominator is calculated in a consistent way cross analysts for all the companies in the peer group. Consequently all analysts should make the same adjustments with regards to the denominator. This is an insurmountable task and would in general only be verified at a very late stage of a process - where the process certainty is close to 100%.

Historical perspective

You might look at a shares historical performance (levels) before you determine whether or not you think the current level is high or low. The same historical analysis is often completed with regards to trading multiples. As the graph on the right illustrates, trading multiples changes significantly over time. Apparently both EBITDA and EBIT currently trade close the the 10y average levels. The graph illustrates the development in NTM multiples.