Calculating, Analyzing, and Using Valuation Multiples.

Overview: You are an analyst for Apple, Inc. and you are worried that the assumptions in your
valuation model are wrong. You are interested in benchmarking the current valuation for Apple
relative to its comparable peers. You pull up your Bloomberg terminal and see that Apple’s Market-
to-Book ratio (market value of Apple’s equity divided by its book value of equity according to its
most recent financial statement) is substantially higher than its peer set of competitors. Is it
(relatively) over-valued? Or are there fundamental value drivers which cause these differences?

One commonly used technique to sanity-check firm valuation is to compare various valuation
multiples across companies. Valuation multiples typically have a value or price in the numerator (e.g.,
market capitalization of equity or total enterprise value, which includes net debt, preferred, etc. in
addition to equity) and an accounting metric in the denominator (e.g., book value of equity, earnings,
EBITDA). We will see that these metrics can vary considerably across even carefully selected peers.

In this assignment, we will show you that two commonly used multiples (Market-to-book (MTB) and
Price-Earning (P/E)) can be directly derived from the Residual Income model, thus showing that these
multiples are really just short-hand versions of more complete valuation analyses. We will also
calculate two other commonly used ratios (Enterprise value-to-EBITDA and Enterprise value-to-
sales) which are more ad-hoc (i.e., not directly derived from a valuation model) but offer some
advantages to MTB and P/E ratios. We will then illustrate how you can use multiples (and comparable
company analysis) to complement your valuation. In the process, we will discuss a bit about what it
means to have a “comparable” peer company.

Important: This assignment goes directly hand-in-hand with Chapter 11 of the textbook. Be sure to
read this material before proceeding. We will not cover the Price-to-Earnings-to-Growth (PEG) ratio,
so you can just skim that section. Also note that you will not be expected to undertake the algebra
necessary to derive these ratios (nor do you even need to memorize any equations). Instead,
understand the intuition behind what is being discussed (more on this below). After reading Chapter
11, read the material below and answer the questions.

Learning Objectives:
1. Familiarize you with MTB, P/E, and Enterprise value ratios:
a) How they can be derived from fundamental parameters of standard valuation models, such
as ROE, g, and Re;
b) Understand how to calculate those ratios and how they can be useful;
c) Explain the differences between equity-based and enterprise value-based ratios;
d) Understand the risks and potential pitfalls of using valuation multiples, including how
accounting issues can lead to “distortions” in multiples across firms.

1
This assignment was developed by Michael Minnis. Copyright 2022. All rights reserved.
 Amazon Part I: Corporate Objectives, Strategy, and Competitive Environment

2. Learn how to identify comparable peer firms and why different firms have different valuation
multiples – i.e., what fundamental factors result in different realized multiples.

Materials:
1. Textbook Chapter 11.
2. “Apple – Analyzing Valuation Multiples – case.xls” spreadsheet sourced from CapitalIQ.

Assignment: Follow these step-by-step instructions. Submit the completed spreadsheet and upload
answers to the questions below. Steps 1 and 2 help you complete the spreadsheet and steps 3 and 4
are the questions that need to be answered.

1. Examine the financial statements. Open the “Apple – Analyzing Valuation Multiples –
case.xls” spreadsheet. You will see several color coded tabs. You will make calculations on the
first tab. I have pasted the actual Apple financial statements on the second tab. Because the ratios
are calculated on a trailing 12 month basis (LTM, or last twelve months) and because Apple has
September fiscal year end, you will see Apple’s last full year financial statements (ended
September 2021) and its first quarter (ended December 2021) which also reports the first quarter
for the previous fiscal year. See how these financial results map into the financial statements
downloaded from CapitalIQ in the next three tabs. You will reference the financial data in the
CapitalIQ financial statements, but I wanted you to be able to see how Apple’s as-reported
financial results compare to CapitalIQ’s standardized version.

2. Calculate the ratios. After getting familiar with the financial statement information, go to the
“Your Calculations” tab. Complete each of the green cells by referencing data from the Income
Statement, Balance Sheet, and Statement of Cash Flows. You should only pull in data from the
“Financial Data” tab for the “Valuation” cells. You will note that the CapIQ column typically
references data from the “Financial Data” and “Trading Multiples” tab, but I want you to recreate
these data points from the raw financial data. Each of the green cells should match the pre-loaded
CapIQ cells except:
a. Market capitalization: will be slightly off due to rounding.
b. Price-to-earnings: CapIQ does not actually report this in the standard package of ratios;
instead they report Price-to-Diluted EPS. I prefer Market capitalization (i.e., Price) divided
by Net income available to common (i.e., Earnings) because this is the formula which directly
ties to the Residual Income model (discussed further below). Diluted EPS has two features
which can be problematic: i) dilution, from items such as stock-based compensation; and ii)
weighted average number of shares rather than number of shares at the end of the year.
Neither of these features is directly linked to the Residual Income model. However,
practically, there often is not much difference in the two calculations of the P/E values as
you will note for Apple.
c. TEV-to-EBITDA: CapitalIQ appears to typically include Operating Lease Liabilities as part
of Enterprise value (TEV). They then add back rent expense in the denominator (i.e., actually
use EBITDAR). HOWEVER, oddly (and I cannot figure out why), for Apple it does not
include operating lease liabilities in the numerator in the set of ratios I downloaded for this
exercise but it does include a rent add-back (i.e., it still uses EBITDAR). The rent expense
should not be added in the denominator if the operating lease liabilities are not added as part

2
 Amazon Part I: Corporate Objectives, Strategy, and Competitive Environment

of the Enterprise value in the numerator. For the other comparable peer companies, CapIQ
included Operating Lease liabilities in the numerator and added back rent in the denominator.
Arguments can be made to include Operating Lease liabilities in the numerator and
EBITDAR in the denominator (e.g., to make these ratios more comparable to non-US
companies which use IFRS), but the main point is to keep the numerator and denominator
consistent. If you include lease liabilities in the numerator (i.e., consider Operating Lease
liabilities as part of the capital structure), use EBITDAR in the denominator. If you do not
include lease liabilities in the numerator (i.e., do not treat lease liabilities as part of financial
obligations – as I have discussed in class with respect to our valuation models), then do not
add back rent expense in the denominator (i.e., just use EBITDA). Be consistent. Generally,
it appears that CapIQ intends to include Operating Leases as part of the capital structure and
use EBITDAR, but for some reason for Apple they just do not do it. Because this is not a
substantial issue, for the purposes of the rest of this assignment we will ignore this
discrepancy and just assume the multiples are comparable across companies.

3. Analyze the ratios and compare to peers. Now that you have calculated the valuation multiples
for Apple, let’s compare them to Apple’s peers, or “comps”. Go to the “Trading Multiples” tab.

a. Before we can consider what the values of the multiples mean, it is worth framing the ratios
in terms of a valuation model. As the book shows (pg. 221), under a simplifying assumption
that ROE remains constant forever and the firm grows at the rate g forever, the Market-to-
Book (i.e., Price-to-Book) ratio equals:
𝐸𝐸𝐸𝐸
𝑀𝑀𝑀𝑀0 𝑅𝑅𝑅𝑅𝑅𝑅 − 𝑟𝑟𝑒𝑒
𝐸𝐸𝐸𝐸 =1+� �
𝐵𝐵𝐵𝐵0 𝑟𝑟𝑒𝑒 − 𝑔𝑔

As the textbook indicates, if we assume a firm’s cost of equity capital (re) is 10%, its ROE
(forever) is 20% and has a perpetual growth rate of 5%, the MTB should be 3 (do the
calculations to see this for yourself). Apple’s MTB is 38 – substantially higher than 3! Why?
Go to the “Operating Statistics” tab. Let’s assume that 10% is a fair cost of equity assumption
for Apple (maybe too high in this environment, but that is fine for now). What operating
statistics could you point to which suggest that Apple should have a MTB greater than 3
(think about the other inputs into the equation above)?

b. Return to the “Trading Multiples” tab. “Comps analysis” is often used to determine the value
of a company. Analysts will pool a set of firms which are comparable to the company being
analyzed (typically based on industry and size). They will then calculate the mean or median
valuation multiple of the pool of comp firms and multiply this ratio by the performance
measure of the analyzed company. Let’s use this approach to value Apple using the
comparable peers’ mean MTB ratio. Find the mean of the MTB of the peers in column F. 2
Multiply this by the book value of Apple’s equity to derive an estimated market
capitalization. What would it be? Does this suggest Apple is over-valued or under-valued?

2
Note that CapitalIQ uses the term “P/BV” (price-to-book value of equity) instead of “MTB” (market-to-book value of
equity). These are just different terms for the same construct.

3
 Amazon Part I: Corporate Objectives, Strategy, and Competitive Environment

c. Note that Apple’s MTB is 38 and the comp set mean is 7.5. Now return to the “Operating
Statistics” tab. Compare Apple’s growth rates (revenues and Net Income) and ROE to the
mean of the peer set. Assuming 10% is the appropriate cost of capital for Apple’s peers
(likely not true if Apple’s is also 10%, given the set of peers which likely have a higher cost
of capital with perhaps the exception of Microsoft), why does it make sense that Apple should
have a much higher MTB than its comps? Note, this is why I make the argument that the
appropriate peer comp set has to be selected not just on industry and size (good proxies for
risk, potentially), but also g and ROE. Of course, if you knew re, g, and ROE for the firm you
are analyzing you do not actually need peers because you can simply solve for the MTB ratio
(and thus the company’s value) using the formula above! There is a bit of a circular reference
problem. The point is that comp analysis is only as good as identifying the peer set.

d. Go to the “Trading Multiples” tab and examine HPE’s MTB ratio. You will note it is 1.1 –
just above the level of 1. Use an assumed re of 12%, set g equal to the LTM revenue growth
rate and ROE equal to LTM ROE and the formula above to calculate HPE’s MTB. You
should get a number slightly larger than the actual MTB of 1.1, but does this MTB
approximately make sense given HPE’s performance – especially relative to Apple’s MTB
with its performance?

e. Return to the “Trading Multiples” tab and examine GOOGL’s P/E multiple. It is only slightly
less than Apple’s. However, you will note that Apple’s MTB is substantially higher than
GOOGL’s. Given the formula relating the MTB to the P/E ratio given at the bottom of page
225 in the textbook (MTB = ROE × P/E), why does this make sense? Use the formula to
estimate its MTB by multiplying its ROE by its P/E ratio. Note that the P/E ratio emphasizes
growth in profitability rather than level of profitability (which the MTB emphasizes along
with growth). Given the growth in Net income for both GOOGL and Apple, does it make
sense that the P/E ratios are somewhat comparable?

f. Finally, we will consider three Enterprise value multiples. TEV-to-revenues, TEV-to-

EBITDA, and TEV-to-EBIT. These ratios are not directly derived from fundamental
valuation models as the MTB and P/E ratios are, nonetheless they are frequently used and
can be useful. One reason they are commonly used is that they are more often meaningful
because Net income or book value of equity can be negative, rendering these ratios
meaningless; whereas EBITDA, and almost certainly revenues, are more frequently positive
allowing us to continue using these multiples. (Be wary, though, the person trying to sell you
a company based on a multiple of sales….) Note that, similar to MTB and P/E, EV multiples
are also increasing in g and decreasing in re (or, technically rWACC). So they have similar
comparisons. However, one unique aspect in comparing these ratios is to note the Net income
and EBITDA margins. For example, note that Apple’s TEV-to-Revenues and TEV-to-
EBITDA multiples are much closer to GOOGL’s than to MSFT’s. Now go to the “Operating
Statistics” tab. What performance measure there is consistent with this result?

g. Another reason that EV ratios differ from MTB and P/E ratios is leverage. Note that HPQ,
DELL, and HPE all have TEV-to-EBIT multiples which are higher than their P/E ratios,
which is different from the other companies in the list. Go to the “Financial Data” tab. Can
you pinpoint why this is? Compare net debt to market capitalization – which set of firms has
more financial structure leverage?

4
 Amazon Part I: Corporate Objectives, Strategy, and Competitive Environment

h. TEV-to-EBITDA is probably more frequently used than TEV-to-EBIT, but the key (obvious)
difference between the two is whether D&A is included in the denominator. As such, TEV-
to-EBITDA may be similar between two companies but TEV-to-EBIT may be very different.
Compare HPQ to HPE, for example. Note the difference between these two multiples for
these two companies. Now go to the “Financial Data” tab – which data point is very different
between these two companies which is likely driving the difference in the two multiples?

4. Multiples expansion and contraction. Analysts often talk about multiples “expansion” and
“contraction”. Given what we have discussed above, what does this mean? Under what scenarios
or situations should a valuation multiple expand (i.e., get bigger)? Contract (i.e, get smaller)?
Consider specifically each of the three parameters (or inputs) into the equation above. What firm
specific and macroeconomic factors may cause multiples to change?

Key take-ways:

1. Understanding the features underlying valuation multiples takes some of the mystery (and
magic) away from them. They are really nothing more than a combination of assumptions about
ROE, g, and re – the exact same set of assumptions needed for a valuation model!

2. Comparable peers (“comps”) are only as good as the matching underlying performance metrics.
If you have peer firms which are not very similar along the value dimensions to your target firm,
then your benchmark multiples are not going to lead to very useful results. I am often asked,
“How do I choose the right comp set?” My response (tongue-in-cheek) is, “Simple: Find
companies with the same cost of capital, ROE, growth trajectories, leverage, and CAPEX needs
– all of the features that affect valuation multiples – of the firm you are interested in analyzing.”
This, of course, leads to frustration because if you already knew all these features, then you
would not need a peer set. But then this is my point – there is no easy way to valuation!

3. The previous statement is, of course, a bit of an exaggeration. Comparables analysis can certainly
be useful in part because it is easy. Moreover, the cost of capital is an important input, and we
often know little about that number – so peer sets can identify firms with similar costs of capital.
Then once selecting that peer set, we can adjust our valuation multiple up or down relative to the
peer set based on differences in g and ROE. Therefore, multiples analysis can still serve as a
useful benchmark, if you know what they mean and how to use them. Moreover, enterprise
multiples are frequently used in private equity settings because, among other reasons, firms in
that setting typically lack useful public data and equity is not liquid, thus reference prices are
less easily available. Multiples can be very useful complementary valuation approaches.