FNCE30011 Essentials of Corporate Valuation Class 7

Professor John Handley

VALUATION USING PE MULTIPLES

Class Outline

• Multiples
• Equity Valuation Using Multiples
• Estimating Future Maintainable Earnings
• Estimating PE Multiples

References
Berk & DeMarzo 5E, Chapters 2.6, 9.4
McKinsey 7E, Chapters 10, 18 (6E, Chapters 8, 16)
Damodaran 3E, Chapters 17, 18
OBJECTIVES FOR TODAY

• What is a multiple ?

• What is a PE multiple and what does it represent ?

• What is the multiples approach to valuation ?

• How do you use PE multiples in valuing a firm ?

• What is future maintainable earnings and how is it estimated ?

• How do you estimate PE multiples ?

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1. MULTIPLES

What Is A Multiple ?

A multiple is a measure of the value of an asset relative to some characteristic of

that asset

Common characteristics include earnings, book values and revenues and operating
metrics such as production, user activity and reserves.

How Are Multiples Used In Valuation ?

McKinsey put it nicely when they state …

“The basic idea behind using multiples for valuation is that

similar assets should sell for similar prices whether they are houses or shares of stock” 1

This means, the stronger the economic argument linking the characteristic of the
asset to the value of the asset, the more sensible the multiple as a valuation tool.

1
McKinsey 7E, p.367 (6E, p.331)
3
What Is A PE Multiple ?

The most common valuation multiple is the price-earnings multiple – which is also
called the price-earnings ratio or simply the PE

The PE multiple of a firm is equal to the share price of the firm divided by its
earnings per share

… it can also be calculated on a whole-of-firm basis – that is, the equity value of
the firm (also called the market cap of the firm) divided by the total after-tax
earnings attributable to its ordinary shareholders
W1

A PE multiple is an example of an equity multiple – we have an equity value in the

numerator and an equity earnings measure in the denominator

The concept of a PE has a sound economic basis …

“The intuition behind its use is that when you buy a stock, you are in a sense buying the
rights to the firm’s future earnings” 2

2
Berk & DeMarzo 5E, p.328
4
The PE ratio of a firm can be based on past, current and or future earnings …

• a historic PE ratio is based on reported earnings for the most recent financial
year

• a trailing 12-month PE ratio is based on reported earnings for the most recent
12-month period

… firms in the U.S. report earnings quarterly whereas firms in Australia report
earnings semi-annually and so trailing twelve months (TTM) earnings are
the reported earnings for the most recent four quarters in the U.S. and for
the most recent two half-years in Australia

… TTM earnings represent the most up-to-date “annual” earnings reported by

a firm in between the release of its annual financial statements

• a forward 12-month PE ratio is based on estimated earnings for the next 12-
month period (or for 12-month periods after that)

PEs can also be based on earnings for the current (or a future) financial or calendar
year and in some cases, may reflect a mix of reported and estimated earnings
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Which PE is Best ?

There is no clear winner since …

• historic and trailing PEs are backward looking but are based on actual
observable earnings

• trailing PEs are at least as good as historic PEs since they are based on the most
up-to-date observable earnings

• forward PEs are forward looking but are usually based on analysts’ estimates
of future earnings and so are subject to error

There is a reporting lag with historic and trailing earnings – for example, quarterly
earnings in the U.S. are reported about 4 to 6 weeks after the end of the quarter

PEs can also be calculated for specific industries and for the overall market using
the prices and earnings of the underlying stocks in a corresponding stock index

… for example, the S&P500 is currently trading at a trailing 12-month (TTM) PE

of 23.1 and a forward 12-month (FTM) PE of 21.1
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Source: The Wall Street Journal (WSJ) at https://www.wsj.com/market-data/stocks/peyields
7
Recall, the dividend yield of a stock is equal to the company’s annual dividend
expressed as a percentage of its current stock price.

Comparing the forward PE and trailing PE for a stock at the same point in time tells
us about the expected growth in earnings across the two periods

… for example, analysts currently expect the earnings on the S&P500 index to
increase by 9.5% over the next 12 months
W2

Extension Note: Ideally, the TTM PE and FTM PE should be based on the same earnings measure but in this case WSJ
use a TTM PE which is based on “as-reported earnings” whereas the FTM PE is based on “operating earnings”.

Extension Note: Accounting Standards require listed (and some other) firms to disclose two measures of earnings per
share. Basic earnings per share is equal to after tax earnings attributable to ordinary shareholders divided by the
weighted average number of ordinary shares on issue during the period. Diluted earnings per share is computed in a
similar way except it includes the potential dilution in earnings that would occur if the firm has any dilutive securities
on issue (such as “in-the-money” convertible securities and options) and these securities were exercised. See chapter
24 of Deegan 9E for further details.

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How Do You Interpret A PE Multiple ?

We will use the notation (instead of ) to refer to the equity value of the firm
or the value of a share of stock if expressed on a per share basis and to refer to
the after-tax earnings of the firm or the EPS at time

It is useful to think about PE ratios within the framework of the FCFE model

(i) First consider a firm with no growth in earnings …

Assume the firm maintains the productive capacity of its existing assets at the
current level such that = = each year. Then the fair value of the
stock today is:

= = = … which implies … =

… which means the PE ratio of a no-growth firm depends on the time value
of money and the risk of its future earnings
W3

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(ii) Now consider a firm with opportunities to grow its earnings …

Value of a firm Value of the firm Value of the firm’s

with growth = with no growth + growth opportunities

= +

… which on rearranging becomes …

= +

… which means the PE ratio of a growth firm also depends on the growth of
its future earnings

Since (i) is a special case of (ii) then we combine to get the following key idea …

The PE ratio of a firm depends on the time value of money and the
risk and growth of its future earnings
W4
So … what could explain a firm with a high PE ? W5

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Example

Consider a firm with current earnings of $10 million per annum. If the firm
currently trades at a PE of 13 and has a cost of equity of 10% per annum, then we
can decompose the PE into …

• one part attributable to current earnings … = 10

• one part attributable to future growth … = − = 13 − 10 = 3

!
… which means of the current value of the firm represents future growth
!

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Importantly, this is only a “first step” to understanding the PE ratio of a firm …

• to go further requires specific assumptions and modelling of the firm’s growth

pattern over time including the firm’s retention (or plowback) ratio and the rate
of return on reinvested capital … more on this in a later class

but it still tells us that …

• risk and growth can explain both cross-sectional variation in PE ratios (that
is, differences in the PEs of different firms at the same point in time) and time-
series variation in PE ratios (that is, differences in the PE of the same firm at
different points in time)

• time value of money (risk-free interest rates) can explain time-series variation
in PE ratios since it is an economy-wide rather than a firm-specific variable

… and it can also indirectly explain cross-sectional variation in PE ratios via

interaction effects with the risk and growth of a firm’s future earnings

… for example, growth firms tend to have longer duration cash flows which
are more sensitive to changes in interest rates
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Let’s look at an example …

W6

13
 W7
Source: The Wall Street Journal (WSJ) at https://www.wsj.com/market-data/quotes/msft . MSFT has a June 30 financial
(or fiscal) year end. TTM EPS is based on actual EPS for the last four quarters of: $2.45, $2.69, $2.99, $2.93. Actual
EPS for FY23 was $9.68 and consensus analyst EPS estimates suggest growth in EPS of 20.0% in FY24, 10.1% in FY25
and 16.7% in FY26.

Extension Note: PEs reported in the WSJ are based on diluted earnings per share. Changes in the weighted average
number of ordinary shares during a year may lead to a small difference in the annual EPS based on annual data
compared to the annual EPS based on summing up quarterly data.
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How Does The Current Market PE Compare To The Past ?

Source: FactSet Research Systems Inc, Earnings Insight, 5 April 2024 at: https://www.factset.com/
Extension Note: A market PE can be useful in high-level strategic asset allocation decisions such as choosing the
portfolio weights to be invested in stocks v. bonds. As Damodaran 7E explains: “Analysts and market strategists often
compare the PE ratio of a market to its historical average to make judgments about whether the market is under- or
overvalued. Thus, a market that is trading at a PE ratio much higher than its historical norms is often considered to be
overvalued, whereas one that is trading at a ratio lower than its historical norms is considered undervalued.”
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2. EQUITY VALUATION USING MULTIPLES

Valuation Using PE Multiples

If we wish to value a firm on a going concern basis then we should be able to use
the firm’s expected future earnings rather than its expected future cash flow

More formally, the value of equity today is equal to the future maintainable
earnings of the firm multiplied by an exogenous price-earnings multiple

= ×

… we will soon discuss where the PE multiple comes from

We can apply this model either on a whole-of-firm basis (in which case, is the
equity value of the firm and is the future maintainable after-tax earnings of the
firm) or on a per-share basis (in which case, is the value of a share of stock and
is the future maintainable earnings-per-share of the firm)

Note we apply an equity multiple to an equity earnings estimate.

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So, to value equity in a firm we need to estimate two things …

• the future maintainable earnings

• the PE multiple

There are other earnings measures we can use to value a firm … more on this next
class

This is also called the capitalisation of earnings approach to valuation since we

apply a multiple to the earnings of the firm to determine the capital value of the firm

Example

Assume a firm is expected to generate future maintainable earnings of $100 million

per annum. Based on an analysis of “similar” firms in the market you decide that a
PE multiple of 10 is appropriate to value the firm.

The equity value of the firm (in $ millions) is then …

= 100 × 10 = 1,000
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Why Do We Need Another Valuation Model ?

The key idea of the multiples approach to valuation is …

You value a firm based on how similar firms are currently valued

The widespread popularity of multiples-based valuation approaches among many

analysts and investors (compared to DCF-based approaches) is largely driven by
practical rather than theoretical considerations …

• it is often not feasible to undertake a full-blown DCF valuation

• earnings, rather than cash flow, is the traditional market measure of a firm’s
performance

• comparable data on earnings and PEs of other firms traded on stock exchanges
is readily available

• comparable data on earnings and PEs of other firms traded in the takeover
market is readily available

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• it is relatively simple to use in valuing unlisted entities and divisions/business
units of a conglomerate firm

• mathematically, it is very simple but this also opens it up to misuse

“In practice, however, multiples are often used in a superficial way

that leads to erroneous conclusions” 3

• it is relatively easy to communicate

Different valuers tend to prefer one approach over another, but often both approaches
(DCF and multiples) are used. For example, McKinsey states …

“Enterprise DCF remains a favorite of practitioners and academics because

it relies solely on the flow of cash in and out of the company
rather than on accounting-based earnings
…

Multiples can be a great check on your DCF valuation if done properly” 4

3
McKinsey 7E, p.367 (6E, p.333)
4
McKinsey 7E, p.177, 203 (6E, p.163, 135)
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What Should We Do About Surplus Assets ?

Recall, when valuing a firm using DCF …

• a surplus asset is not used in generating the free cash flow of the firm

• surplus assets should be valued separately

• any cash flow associated with a surplus asset should be ignored when
determining the enterprise value of the firm excluding surplus assets % &

Similarly, when valuing a firm using multiples …

• observed stock market multiples may be distorted by surplus assets

and so …

• PE multiples should be based on the equity value excluding surplus assets

&
and earnings excluding any income or expense items associated with the
surplus asset

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3. ESTIMATING FUTURE MAINTAINABLE EARNINGS

What Is Future Maintainable Earnings ?

Future maintainable earnings is …

• the after-tax earnings that the firm is expected to generate from its operations
each year in the long-run

• is a proxy for expected FCFE generated by the firm assuming no growth

As Lonergan Edwards nicely explain in a recent Independent Expert Report …

Source: Lonergan Edwards & Associates Limited, 2017, Warrnambool Cheese and Butter Factory – Independent
Expert’s Report, 14 February, p32.
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How Do You Estimate Future Maintainable Earnings ?

If you want to value a business then you need to understand the business

… which illustrates why, in practice, valuation reports including IERs contain

substantial analysis and commentary on the business being valued and the
industry within which it operates

Future maintainable earnings is not necessarily equal to past earnings but often the
starting point is the most recent TTM earnings and or FTM earnings

… analysts then take a forensic look at these earnings (and at the earnings over the
prior few years and any forecasts over the next few) to determine whether it is
indeed a sensible proxy for estimating the future earnings of the firm.

… adjustments are required if the earnings include

• one-off items

• income (or expenses) from surplus assets

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There should however be no adjustment or allowance for growth in future
maintainable earnings

… since growth is reflected in the PE ratio and doing so would amount to double
counting

Future maintainable earnings is also called normalized earnings

Extension Note: Adjustments may also be needed for any expected accounting or regulatory changes (such as changes
in the statutory tax rate) and for any differences in accounting policies used by the firm being valued compared to the
polices used by the comparator firms.

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4. ESTIMATING PE MULTIPLES

How Do You Estimate a PE Ratio ?

The PE ratio used in valuing a firm is commonly determined by looking at …

• the PE ratios of comparator firms which are listed and trade on a stock
exchange – often called stock market multiples

• the PE ratios at which comparator firms have been bought and sold in recent
transactions in the takeover market – often called transaction multiples

But there is an important difference in the PEs obtained from these two sources …

• stock market multiples are based on prices which usually reflect small trades
in minority parcels of shares and therefore do not include a premium for control

• transaction multiples are based on prices which reflect a change of control of

a firm and therefore likely include a premium for control

Extension Note: Transaction multiples have the advantage of indicating the actual prices paid to acquire comparable
firms in the past but suffer from the disadvantage that the data is often less transparent and dated.
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How Do You Choose A Comparator Firm ?

Comparator firms are also called comparable firms and a set of comparator firms
is also called a peer group

The key consideration in selecting comparator firms is to allow us to compare

like-with-like

… which means we want firms which have the same or at least similar operations
to the firm being valued

The common starting point is to look at listed firms in the same industry …

“A comparable firm is one with cash flows, growth potential, and risk similar to the firm
being valued. It would be ideal if you could value a firm by looking at how an exactly
identical firm—in terms of risk, growth, and cash flows—is priced. Nowhere in this
definition is there a component that relates to the industry or sector to which a firm belongs.
Thus a telecommunications firm can be compared to a software firm if the two are identical
in terms of cash flows, growth, and risk. In most analyses, however, analysts define
comparable firms to be other firms in the firm's business or businesses.” 5
5
Damodaran 3E, Chapter 17
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Once you have chosen your set of comparator firms you then estimate the PE of each
comparator firm based on its …

• TTM earnings and or FTM earnings after adjustments to remove the impact
of any one-off items and surplus assets

• current stock price

From which you choose the PE to be used in your valuation …

• usually there are differences in the set of PE ratios which first need to be
examined and “reconciled” using mostly qualitative judgments

“no two firms are identical and firms in the same business can still differ on risk,
growth potential, and cash flows. The question of how to control for these differences, when
comparing pricing across several firms, becomes a key one.” 6

• but we know exactly what to focus on when doing this …

risk and growth

W8
6
Damodaran 3E, Chapter 17
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Let’s look at an example . You have been asked to value General Motors Co.
using the PE approach. The following has been extracted from The WSJ …

Would you use these PEs to value General Motors … and if so, how ?
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The Key Idea is …

It makes sense to use the PE multiple approach to valuation

when you have access to reliable data on comparator firms

Other issues to consider when using PE multiples include …

• it is implicitly assumed that the PEs of comparator firms are “correct”

• the PEs of comparator firms should be based on the same earnings measure used
to estimate the future maintainable earnings of the firm being valued

… for example, if you use adjusted TTM earnings to estimate then you
should use the adjusted TTM earnings of comparator firms to estimate PEs

• PEs are based on earnings after interest and after tax which means PEs of
comparator firms may be distorted by differences in leverage and taxes

… which explains why other earnings measures are also often used in practice
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