Price multiples, enterprise value and asset-based valuation

Why do analysts use price multiples?

A price multiple compares a share’s price with some monetary figure per share, such as earnings, sales, cash flow or book value. It tells you how much investors pay for each unit of that figure, and so how the share compares with others. Multiples are easy to compute, widely published and good for screening a sector for relatively cheap or dear shares.

Price multiplesprice divided by a per-share fundamental; trailing or forward, but be consistent

• P/E (price to earnings) Memorize the most quoted; but negative or one-off earnings distort it
• P/B (price to book value) Memorize good for banks and asset-heavy firms; ignores intangibles
• P/S (price to sales) Memorize positive even with losses and hard to manipulate; ignores costs
• P/CF (price to cash flow) Memorize less affected by accruals; cash flow definitions vary

The trailing P/E uses earnings per share for the last year or last four quarters. The forward (leading) P/E uses forecast earnings. A criticism of any trailing multiple is that it looks backward. The fix is a forward multiple, but then the forecasts are doing the work. Whichever you choose, apply it the same way to every company you compare.

$$P/E_{trailing} = \frac{P_0}{E_0}, \quad P/E_{forward} = \frac{P_0}{E_1}$$

The other common multiples divide the price by sales per share, by a measure of cash flow per share (operating cash flow or free cash flow), or by book value per share. Price-to-sales stays positive when earnings are negative and is harder to manipulate than earnings, but it ignores costs. Price-to-cash-flow is less affected by accounting accruals, but cash flow definitions vary. Price-to-book suits asset-heavy firms and banks, but ignores intangibles.

$$P/S = \frac{P}{\text{sales per share}}, \quad P/CF = \frac{P}{\text{cash flow per share}}, \quad P/B = \frac{P}{BVPS}$$

How does P/E relate to fundamentals?

A multiple is not arbitrary. Take the Gordon growth model with price equal to value: $P_0 = D_1 / (r - g)$. Divide both sides by next year’s earnings $E_1$ and the dividend becomes the payout ratio $p = D_1/E_1$. The result is the justified P/E , the multiple that fundamentals support.

$$\frac{P_0}{E_1} = \frac{D_1/E_1}{r - g} = \frac{p}{r - g}$$

Because $P_0/E_0 = (P_0/E_1)(1 + g)$, the trailing version is the forward version times $(1 + g)$.

$$\frac{P_0}{E_0} = \frac{p\,(1 + g)}{r - g}$$

The formula tells you which way each driver pushes the multiple. The P/E rises with growth and falls with the required return, so riskier companies deserve lower multiples. It also appears to rise with the payout ratio. That last link needs care, because a company that pays out more retains less and so grows more slowly (sustainable growth is $b \times ROE$). The effects interact.

Go deeper Payout against growth

Take return on equity (ROE) = 12% and r = 9%. If the payout is 30%, growth is 0.70 × 12% = 8.4% and the forward P/E is 0.30 ÷ (0.09 − 0.084) = 50.0. At 50% payout, growth is 6.0% and the P/E is 0.50 ÷ 0.03 = 16.7. At 70%, growth is 3.6% and the P/E is 0.70 ÷ 0.054 = 13.0. Here the P/E falls as the payout rises, because the company earns more on retained money (12%) than shareholders require (9%). Retention creates value only when ROE is above r. This is the “dividend displacement of earnings”.

How does the method of comparables work?

The method of comparables is the most widely used approach to price-multiple valuation. Its logic is the law of one price : identical assets should sell for the same price. Choose a benchmark multiple (a closely matched stock, or the average or median of the industry, or the company’s own history) and multiply it by the company’s own fundamental. The difference from a justified multiple is where the expectations come from: a justified P/E is built from your own forecasts of payout, growth and risk, while a comparables multiple takes the market’s pricing of similar companies as given.

$$V = \text{benchmark multiple} \times \text{company fundamental}$$

Three cautions follow.

• Relative, not absolute. A company at a P/E of 18 against peers at 22 is relatively undervalued. The whole peer group may be overvalued, and the share may be dear against its intrinsic value.
• Pick the peers carefully. Match on industry, size, product mix, growth and risk. The justified P/E formula tells you what to match on: payout, growth and required return. Use forward or trailing for all, and adjust for accounting differences.
• Cyclical companies have multiples that swing with the economy, because earnings swing more than sales.

What is enterprise value?

Price multiples value only the equity. Enterprise value values the whole business. It is market capitalization plus the market value of debt, preferred stock and minority interest, minus cash and short-term investments. It is often described as the cost of a takeover: the buyer takes on the debt but receives the cash.

$$EV = \text{market cap} + \text{debt} + \text{preferred} + \text{minority interest} - \text{cash and short-term investments}$$

Enterprise value (EV)roughly the cost of buying the whole business

• Market value of equity Memorize price × shares
• plus Market value of debt Memorize a buyer takes on the debt
• plus Preferred stock Memorize a senior claim
• plus Minority interest Use it subsidiary earnings consolidated but not fully owned
• minus Cash and short-term investments Memorize a buyer gets the cash; never add it

The usual enterprise multiple is EV/EBITDA . EBITDA is earnings before interest, taxes, depreciation and amortization, a rough proxy for operating cash flow. It is calculated before any payment to lenders, preferred holders or shareholders, so it pairs naturally with a value that includes all of them.

$$\frac{EV}{EBITDA}$$

Why use it?

• It compares companies with different capital structures. Both EV and EBITDA belong to all the capital providers together, so how a company splits its funding between debt and equity does not distort the ratio.
• It can be computed when net income is negative, since EBITDA is usually still positive, so the P/E is not available.
• It is popular in Europe and for capital-heavy industries.

If debt has no market quotation, estimate its market value from bonds with similar maturity, sector and credit quality. Using the book value of debt is only a rough substitute.

An alternative to EBITDA is operating income or revenue. Negative ratios, such as a negative EV/operating income, are hard to interpret and are set aside.

What is asset-based valuation?

Asset-based valuation estimates the fair value of a company’s assets and liabilities and takes the difference. Fair value usually starts with the balance sheet’s carrying value , also called book value , and adjusts toward market value.

$$V = \frac{\text{fair value of assets} - \text{fair value of liabilities}}{\text{shares}}$$

Asset-based valuationfair value of assets minus liabilities

• Works well Use it few intangibles; mostly current or marketable assets
  • Examples banks, investment holding firms, natural resource firms, private companies, liquidations
• Works badly Use it value sits in things the balance sheet cannot show
  • Valuable intangibles software, brands, customer relationships: gives only a floor
  • Specialized or hard-to-price assets fair value differs from carrying value
  • Hyperinflation asset values harder to estimate

The approach works best for companies with few intangible assets and a high share of current or marketable assets. These are easier to value from balance sheet items. It is also frequently combined with multiplier models to value private companies, and it becomes more useful as public companies disclose more fair values.

It works badly where value lives off the balance sheet: a good reputation, synergies, a skilled owner. In those cases it gives a floor value, and a forward-looking cash flow valuation is better. Property, plant and equipment without observable market values are hard to price, and in hyperinflation asset values are hard to estimate.

Exam tip Match the model to the thing you can measure: cash flows for a stable payer, peers for a listed company with comparables, fair-valued assets for a bank, a holding company or a liquidation.

Go deeper Valuing a small private firm

Take a family printing business that owns its building and presses. An analyst gets two appraisals for the building, subtracts the loan secured on it, and values the presses at what equivalent used machines cost to buy. That gives a value for the tangible assets. The business may also have a loyal customer base and a good location, which the asset-based approach excludes. The result is therefore a floor, and the analyst would cross-check it with a multiple of earnings or revenue for similar businesses.

Go deeper Why EV multiples are common in Europe and in capital-heavy industries

In capital-heavy industries, such as telecoms and utilities, depreciation and interest are large and differ between companies according to their accounting policies and funding. EBITDA sits above both, and enterprise value includes all the funding. The ratio therefore compares operations more cleanly than the P/E. Its weakness is that EBITDA ignores the cost of replacing the assets, so it can flatter a business that needs heavy ongoing investment.

Go deeper Backing out the growth a peer multiple implies

Rearrange the justified P/E: $g = r - p/(P_0/E_1)$. A peer trading at a forward P/E of 20 with a payout of 40% and a required return of 9% implies growth of 9% − 0.40/20 = 7%. If that is more than you believe the company can sustain, the multiple is expensive, and a comparable that looks cheap against it may not be a bargain.