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Bhargav Maniar*
The study attempts to understand the various factors influencing popular pricing multiples in the Indian context. The
accounting fundamentals, as observed by earlier researches, and return on investment are considered as factors
influencing pricing multiples. The reference securities are adopted from the Nifty index. 1-year return found
significance in three models—P/E, EV/EBITDA and Price to Sales. Next year growth in earnings, market beta,
dividend payout ratio, return on equity and profitability margin are important for certain specific multiples. The models
follow intuitive inferences (e.g., margin as a factor influencing sales multiple), show importance of absolute return on
investments and analyst forecasts (growth next year) vis-à-vis earlier researches.
Introduction
Valuation of equity shares is an important aspect of corporate finance. Valuation analysis is
performed on a number of corporate events such as public issue, merger, de-merger and ESOP
issuance. Analysts also value listed securities frequently to give their views on respective
securities (Buy/Sell/Hold/Overweight/Underweight). There are various techniques for valuing
an equity share. The most fundamental technique is discounting of future cash flows associated
with such equity share. However, estimating future cash flows involves multiple assumptions
and hence becomes highly subjective.
Multiple studies show a general preference towards more transparent and objective
measures like relative price to earnings ratio (P/E ratio) as compared to the more complex
valuation techniques like discounted cash flows (Lie and Lie, 2002). Barker (1999) studied
the various approaches used by different analysts and inferred that P/E ratio was of primary
importance, and technical analysis, and beta analysis are of little practical importance to
investment decisions. A similar study by Demirakos et al. (2004) also indicated preference for
multiples—67% of the analysts studied by the authors used multiples for valuation analysis.
Security analysts in India have been using multiples quite significantly as their international
counterparts. The author observed select analyst reports and found extensive usage of multiples
for valuation analysis.
The multiples are one of the simplest tools to compare the value of a firm. A multiple is
simply the ratio of a market price variable (e.g., stock price) to a particular value driver
(e.g., earnings) of a firm. Practitioners can compare firms within the same industry or past
transactions based on a value driver and calculate multiples. Such multiples can be applied to
the company under study and an estimate of its value can be generated. This methodology is
* Senior Associate, Investment Banking, ICICI Securities Limited, Mumbai, Maharashtra, India.
E-mail: maniar.bhargav@icicisecurities.com
† Disclaimer: This paper is prepared by Bhargav Maniar in his personal capacity. The opinions expressed in this
article are the author’s own and do not reflect or should not be construed as views of ICICI Securities Limited
or ICICI Bank Limited or any entity in ICICI Group in any manner whatsoever.
© 2014 Influencing
Factors IUP. All Rights Reserved.
Pricing Multiples in India 23
applied for fundamental analysis of listed companies, valuation analysis for unlisted companies
during mergers and acquisitions, equity investments, ESOP valuations, mergers, acquisitions, etc.
This brings us to the next question—What will be driving these multiples? How is a
security which is traded at 25 times its earnings different from the one which is traded at 10
times its earnings? There could be many fundamental factors which one can use to justify
differences in multiples such as profitability, strength of business model, cost structures, and
uniqueness of product portfolio. Many of them reflect in various financial ratios such as
profit margins, return on equity and relative growth forecasts, and could have bearing on
multiples. Popular multiples and the factors influencing such multiples are the subject matter
of this study. Specifically, the study intends to understand: What are the relevant fundamental
factors in the Indian context? Which factors have higher bearing on which multiple? And is
it possible to predict multiples using combination of various fundamental factors?
Literature Review
There have been various studies to understand what factors influence various multiples. One
of the most widely known and applied studies has been the Damodaran’s Regressions of Multiples
on Fundamentals being published in January every year since 2005. Damodaran has been
creating regression models on multiples including Price to Equity, Price to Book Value, Price
to Sales, Enterprise Value (EV)/Invested Capital, EV/Sales, and EV/EBITDA. The
fundamental parameters used to estimate these multiples include: Return on Equity (ROE),
[Dividend] Payout Ratio, Expected Growth in Earnings Per Share (EPS) for next five years,
Return on Invested Capital, Operating Margin, Beta, and Reinvestment Rate.
In one of the earlier studies, Kisor and Whitbeck (1963) developed a regression model of
P/E ratios with independent variables growth rate in earnings, dividend payout ratio and
standard deviation in EPS changes. They used data from the Bank of New York for 135 stocks
as base. A similar analysis by Cragg and Malkiel (1968) established growth rate, payout ratio
and beta for stocks as dependent variables. Zarowin (1990) studied the relationship between
P/E ratios and analyst forecasts of growth and concluded that long-term growth has a positive
impact on P/E ratios.
Leibowitz and Kogelman (1990), (1991) and (1992) studied the relationship between P/E
ratios and the excess returns earned on investments, which they titled franchise opportunities,
in a series of articles on the topic, noting that for a stock to have a high P/E ratio, it needs to
generate high growth in conjunction with excess returns on its new investments.
Beaver and Morse (1978) correlated P/E ratios of a particular portfolio for 14 years and
observed that the P/E ratios show greater correlation with each other in the near term. The
correlation reduces as the time progresses. This implies that near term forecasted earnings
could have higher influence on P/E ratios vis-à-vis long-term growth forecasts. Kane et al.
(1996) showed the influence of aggregate market risk and volatility, and conveyed that P/E
ratios decrease as volatility increases. Liu et al. (2002) compared different multiples of select
firms between 1982 and 1999 and suggested that multiples of forecasted EPS do best in
explaining pricing differences.
Methodology
The current analysis intends to examine the factors influencing different multiples. Hence,
two statistical tools, namely, correlation and regression, have been used. These tools have
been used by earlier researches as well—notably Kisor and Whiteback (1963), Liu et al.
(2002), and Damodaran (2005)—who observed various fundamental factors and derived
relevant factors in their respective contexts. The author maintains similar methodology—
selecting factors from earlier researches and adding return on investment dimension to
the analysis.
The following multiples were found popular in the Indian context: Price to Earnings
(P/E), EV/ EBITDA (found more relevant to manufacturing or engineering companies),
Price to Sales (found more relevant in trading and manufacturing companies) and Price to
Book Value (popular in companies engaged in financial services like banks, NBFCs). The
study uses these four multiples as dependent variables in four different regression models.
The National Stock Exchange (NSE) is the dominant stock exchange in India with market
share of 74% in equity market and 98% in equity derivatives. Nifty is the index developed by
NSE representing the top 50 companies traded on the exchange weighted by market
capitalization. The Nifty securities cover 22 sub-sectors of the Indian economy and represent
Unlevered Beta (Beta)* Cragg and Malkiel (1968), Kane et al. (1996), Tuli and
Mittal (2001) and Damodaran (2005 onwards)
Best estimate of growth rate in earnings Cragg and Malkiel (1968), Beaver and Morse (1978),
per share for next financial year Zarowin (1990), and Liu et al. (2002)
(next year growth)
Best estimate of growth rate in Cragg and Malkiel (1968), Beaver and Morse (1978),
earnings per share for next five Zarowin (1990), and Liu et al. (2002)
years (5-year growth)
Dividend Payout Ratio Kisor and Whitbeck (1963), Cragg and Malkiel (1968),
Zahir and Khanna (1982), Kumar and Hundal (1986)
and Tuli and Mittal (2001)
Return on Equity (ROE) Leibowitz and Kogelman (1990), (1991), and (1992),
and Damodaran (2005)
Return on Capital Employed (ROCE) Leibowitz and Kogelman (1990), (1991), (1992), and
Damodaran (2005)
Results
The study intends to explain the variations among the multiples. Table 2 shows the mean
and deviations from mean among the multiples under study.
The highest variability, as measured by coefficient of variation, is observed in the price to book
value multiple and the least within EV/EBITDA.1 The variability is considered important by
analysts, especially when the security under observation is to be benchmarked against an industry
average. As EV/EBITDA has least variability, it is more popular with analysts. This multiple
focuses on operating performance and negates the potential impact of capital structure decision.
Correlations
The influencing parameters have been segregated into:
1. Accounting fundamentals such as profitability margin, leverage, ROE, and ROCE.
2. Market risk—Beta.
1
The author has excluded banking stocks in the entire analysis pertaining to EV/EBITDA multiple as the
EVITDA or EV is not relevant in banking sector.
Price to 0.04 –0.38 0.40 0.51 –0.56 0.69 0.26 0.64 0.58 0.48
Earnings
EV/ –0.02 –0.14 0.32 0.41 –0.42 0.31 0.27 0.65 0.52 0.43
EBITDA
Price to –0.10 –0.30 0.65 0.76 –0.50 0.32 0.25 0.44 0.52 0.58
Book Value
Price to Sales 0.47 –0.21 0.22 0.29 –0.37 0.32 0.16 0.56 0.47 0.32
Note: Profitability indicates PAT margin, except EV/EBITDA multiple for which the reference is EBITDA
margin.
The highest correlation is observed between price to book value multiple and ROCE,
followed by ROE and price to book value multiple. ROE and ROCE are measures of capital
efficiency and hence could be a proxy for how two companies with same amount of net worth
could be differentiated.
All the multiples show notable correlation with market beta. P/E ratio is the most sensitive
to market beta, followed by price to book value ratio. Negative correlation indicates general
risk aversion—securities with higher beta or higher risk would command lower value.
Significant correlation can be observed between P/E and earnings forecast for next financial
year. In general, next year growth appears to be more important than long-term growth in
pricing of securities.
Return provided by the security in last financial year (return is a composite of change in price
of the security net of any bonus and dividend paid during last one year) showed higher bearing on
all multiples, except price to book value which was more correlated to dividend payout.
Regression Models
The influencing factors were arranged as independent variables in decreasing order of their
correlation with the respective multiple, and regression exercise was run. The factors showing
less than +/– 0.2 correlations were ignored for modeling purpose. Table 4 presents the outputs
of the models of each multiple.
Dependent Variables
Independent Variables Price to Earnings EV/EBITDA Price to Book Value Price to Sales
1-Year Return 0.20 8E-04* 0.15 4E-03* 0.05 0.1*** 0.04 1E-03**
5-Year Return –0.13 0.25 –0.02 0.86 –0.01 0.78 0.02 0.50
Growth Next Year 0.11 3E-04** 0.00 0.84 –0.01 0.35 0.00 0.92
Dividend Payout 0.11 0.14 0.06 3E-01* 0.07 5E-02** 0.01 0.44
Conclusion
On the whole, 1-year return, growth estimate for next year, dividend payout and market beta
found place in more than one model. This indicates that market considers these four factors
as critical in valuing a stock—irrespective of which multiple is deployed.
References
1. Barker R (1999), “The Role of Dividends in Valuation Models Used by Analysts and
Fund Managers”, The European Accounting Review, Vol. 8, No. 2, pp. 195-218.
3. Cragg J G and Malkiel B G (1968), “The Consensus and Accuracy of Predictions of the
Growth of Corporate Earnings”, Journal of Finance, Vol. 23, No. 1, pp. 67-84.
4. Damodaran A (2005), Valuation Approaches and Metrics: A Survey of the Theory and
Evidence, Now Publishers, Hanover, Massachusetts.
8. Kane A, Marcus A J and Noh J (1996), “The P/E Multiple and Market Volatility”,
Financial Analysts Journal, Vol. 52, No. 4, pp. 16-24.
10. Kumar and Hundal (1986), “Stock Market Integration Examining Linkages Between
India and Selected Asian Markets”, Foreign Trade Review, Vol. 45, pp. 3-18.
11. Leibowitz M L and Kogelman S (1990), “Inside the PE Ratio: The Franchise Factor”,
Financial Analysts Journal, Vol. 46, No. 6, pp. 17-35.
12. Leibowitz M L and Kogelman S (1991), “The Franchise Factor for Leveraged Firms”,
Financial Analysts Journal, Vol. 47, No. 6, pp. 29-43.
13. Leibowitz M L and Kogelman S (1992), “Franchise Value and the Growth Factor”,
Financial Analysts Journal, Vol. 48, No. 1, pp. 16-23.
14. Lie E and Lie H (2002), “Multiples Used to Estimate Corporate Value”, Financial Analysts
Journal, Vol. 58, No. 2, pp. 44-54.
15. Liu J, Nissim D and Thomas J (2002), “Equity Valuation Using Multiples”, Journal of
Accounting Research, Vol. 40, No. 1, pp. 135-172.
16. Mangala D and Mittal R K (2005), “Anomalous Price Behavior: An Evidence of Monthly
Effect in Indian Stock Market”, The Indian Journal of Commerce, Vol. 58, No. 2,
pp. 65-70.
17. Obaidullah M (1991), “The Price/Earnings Ratio Anomaly in Indian Stock Markets
Decision”, A Journal by IIM Calcutta, Vol. 18, July-September, pp. 183-192.
18. Sehgal S and Pandey A (2007), “The Behavior of Price Multiples in India
(1990-2007)”, Asian Academy of Management Journal of Accounting and Finance, Vol. 5,
No. 1, pp. 31-65.
19. Tuli N and Mittal R K (2001), “Determination of Price-Earnings Ratio”, Finance India,
Vol. 15, No. 4, pp. 1235-1250.
20. Zahir M A and Khanna Y (1982), “Determinants of Stock Prices in India”, The Chartered
Accountant, Vol. 30, No. 8, pp. 521-523.
Appendix
Damodaran’s Emerging Market Regressions – January 2012
Model R2 (%)
Price to Earnings = 15.48 + 9.03 ROE – 2.77 Beta + 2.91 Payout 4.3
EV/Invested Capital = 1.28 – 0.40 RIR + 4.64 ROIC – 0.03 (Debt/Capital) 27.4
EV/Sales = 1.67 – 2.70 t + 8.25 Operating Margin – 0.002 IC – 0.29 RIR 31.7
Note: RIR = Re-Investment Rate; ROIC = Return on Investment Capital; IC = Interest Coverage
Ratio; t = Tax Rate.
Reference # 01J-2014-01-02-01