Multiplier Method

Business Analysis and Valuation

Basics of multiplier method

V
V X
X

Value Driver

Multiple

Two Principles to Remember:

X is a value driver (a determinant of V)
V and X are consistent with each other
Is X determining the value of equity or that of the
firm?
Is X the outcome of capital contributed by all
providers of fund or the equity shareholders
alone?
Is X available for distribution to all providers of
fund or to the equity shareholders?

Few Examples
Black Coal Limited

Very Black Coal Limited

Coal Reserves

5,000 MMT

10,000 MMT

Annual Extraction

100 MMT

100 MMT

Profit

$1,000 million

$1,000 million

Old Cement Ltd.

New Cement Ltd.

Capacity

100 Mton

120 Mton

Capacity Utilization

95%

75%

EBITDA

Rs.100 million

Rs.85 million

Net Income

Rs.40 million

Rs.36 million

Small Bazaar

Medium Bazaar

Net Fixed Assets

Rs.900 million

Rs.2,000 million

EBITDA

Rs.150 million

Rs.500 million

Stores owned/leased

30/10

50/50

Three Steps to follow while using

multiplier method
Understand

the theoretical properties of the multiple

Analysts

are going to use multiples anyway. So our

objective is to see how best to use these multiples.

Amazon

is trading at 517.54 times its ttm EPS ($0.64 per

share)
Find
Find

comparable companies

out at what level the comparable companies

should trade

1. Price Earnings Ratio

PE = Market Price per Share / Earnings per Share

Price:

is usually the current price

EPS:

Time variants: EPS in most recent financial year (current), EPS in most recent four
quarters (trailing), EPS expected in next fiscal year or next four quarters (both
called forward) or EPS in some future year

Your interpretations will be slightly different.

Primary, diluted

PE(ttm) or forward PE?

The ttm-EPS of a company is Rs.20 per share.

The one-year forward EPS is Rs.25 per share.

Current price is Rs.200.

Suppose the median comparable company PE is 12.

So how will I state my recommendations?

Basic and Diluted EPS

A company had 1,000,000 shares outstanding as on 1 April 2012. It issued an

additional 200,000 shares on 1 June 2012.

Assume that the company has issued 50,000 convertible bonds (with face value
of 100 each) that carry a coupon of 10% per annum. These convertible bonds
can be converted into 1 share each. Assume that these bonds were outstanding
in the beginning of the year itself.

Assume that the stocks of SMPM are trading at 100 per share.

The company has also issued 500,000 stock options to its employees. The
employees have the right to buy additional shares of SMPM at a price of 30
per share.

Analysts expect a total profit after tax of 2,000,000 for the year ending 31
March 2013 from SMPM.

Price-Earnings Ratio
ROE g
PER
ROE ( K e g )

Growth, risk and profitability are the three key value

drivers.

Which one is more important?

Analyzing PER of Sensex

Average ROE of Sensex 30 companies is: 16.06%

Average g can be taken to equal 10%. Can use a lower figure as well.
Risk-free rate: 8.55% (end of 5 August, 2013)
MRP: around 7.13%.
We can find the implied PER. It comes to 6.64.
We can also find the implied MRP. It comes to 3.51%.

Another way of looking at PE Multiple

P 1 NPVGO

E Ke
E
When can we compare the PE Ratios?
Ke must be comparable
Similar rf
Similar MRP
Similar beta (risk)
NPVGO must be comparable
Similar growth opportunities
Who should be more worried about meeting the analysts earnings
target? A high-growth company or a low-growth company?

Getting a sense of the distribution

All Listed Companies in BSE and NSE

MIN PER is 0.39. The Maximum is 1261. The median is 19.92 and the mean is 69.57

Biased upward in this data as all negative PE companies removed from the sample.

R-codes
> per1<-subset(PER,PER>11.66 & PER<37.11)
> hist(per1)

Distribution of Nifty PER

Quick Summary:
> summary(PER)
Min. 1st Qu. Median Mean 3rd Qu. Max.
7.70 15.55 19.65 33.47 29.60 500.00

NA's
2

Distribution of PER of FMCG Companies

Histogram after removing top and bottom 25%
of the data

> summary(PER)
Min. 1st Qu. Median

Mean 3rd Qu.

Max.

26.89 34.29 43.91 50.76 59.16 96.07

PER and Growth

ROE K e
PER
1

g
ROE ( K e g ) 2
Lower the Ke, higher will be the
impact of g on PER.
Lower is Ke g, higher is the
impact of g on PER.

PER and Growth for Indian Companies

R Codes:
> plot(GROWTH,PER,xlab="Growth in EPS", ylab="PriceEarnings Ratio",col="blue")
> abline(lm(PER~GROWTH))

PER and GROWTH for FMCG Companies

> fmcg.lm<-lm(PER~GROWTH)
> summary(fmcg.lm)
Call:
lm(formula = PER ~ GROWTH)
Residuals:
Min
1Q Median
3Q
Max
-13.930 -2.877 1.152 6.090 10.731
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 24.419
4.077 5.990 0.000205 ***
GROWTH
108.400 13.384 8.099 2.01e-05 ***

R Codes
> plot(GROWTH,PER)
> abline(lm(PER~GROWTH))

PE and Risk
PER
1
ROE g

K e
ROE ( K e g ) 2

PER and Risk

Suppose

you are managing a company with beta of

2 and growth rate of 20%. What is your key value
driver?
Increasing

growth or reducing risk?

PE and ROE
PER
g

ROE ROE 2 ( K e g )
Higher the g, and lower the ROE,
higher will be the impact of a change of
ROE on PER.

The Perfect Undervalued Company

If you were looking for the perfect undervalued company, it would

be one

With a low PE ratio (so that it is cheap)

With a high expected growth rate in earnings

With low risk (and cost of equity)

And with high ROE

Try Yahoo Screener for U.S. Stocks

http://screener.finance.yahoo.com/stocks.html

Is ITC undervalued?

Solution: The Regression Approach

When not to use PER

Valuing high growth companies

High growth >>> high investment >>> low EPS

Amazon (CFI/CFO 78%). Earnings growth estimates are 41% for the next 5 years.

Valuing companies with natural resources

While valuing REITs

When revenue of one year does not tell us anything about revenue of future
years

When current earnings are not sustainable

In 2012, Apple registered 71% increase in iPhones, 61% increase in iPads. These rates
declined to 16% and 3% respectively in 2013.

PEG Ratio
PEG

PER
ROE g

g
( g 100) ROE k e g

What analysts normally assume about PEG

PEG Ratio: FMCG Sector

> peg.lm<-lm(PEG~GROWTH)
> summary(peg.lm)
Call:
lm(formula = PEG ~ GROWTH)
Residuals:
Min
1Q Median
3Q
Max
-1.05341 -0.07725 -0.02338 0.35102 0.76645
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 3.3176
0.3035 10.930 1.7e-06 ***
GROWTH
-3.2181
0.9965 -3.229 0.0103 *

PEG and growth rate

A Variant on PEG Ratio: The PEGY ratio

The PEG ratio is biased against low growth firms because the relationship
between value and growth is non-linear. One variant that has been devised to
consolidate the growth rate and the expected dividend yield:
PEGY = PE / (Expected Growth Rate + Dividend Yield)

A company has a PE ratio of 16, an expected growth rate of 5% in earnings and

a dividend yield of 4.5%.

PEG = 16/ 5 = 3.2

PEGY = 16/(5+4.5) = 1.7

Concept Test
Technology Industry of India and PE Ratio

PER of Technology Companies (part of

BSE Tech-Index)

Regression Output
> tech.lm<-lm(PER~GROWTH)
> summary(tech.lm)
Call:
lm(formula = PER ~ GROWTH)
Residuals:
Min
1Q Median
3Q Max
-16.495 -10.860 -6.082 1.770 60.792
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 25.233
4.336 5.819 8.92e-06 ***
GROWTH
27.742 25.264 1.098 0.285

> summary(tech.lm1)
Call:
lm(formula = PER ~ GROWTH + ROE)
Residuals:
Min
1Q Median
3Q
Max
-16.656 -11.371 -5.889 5.797 54.516
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 37.956
8.241 4.606 0.000171 ***
GROWTH
15.218
25.049 0.608 0.550336
ROE
-59.624
33.424 -1.784 0.089629 .

Final Regression Output

> summary(tech.lm2)
Call:
lm(formula = PER ~ GROWTH + ROE + Beta)
Residuals:
Min
1Q Median
3Q
Max
-14.630 -6.459 -2.192 1.793 27.808
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 21.138
11.961 1.767 0.0951 .
GROWTH
12.887
18.995 0.678 0.5066
ROE
-23.598
25.384 -0.930 0.3656
Beta
7.186
10.575 0.680 0.5059

Book Value Multiples: Indian Stocks

> summary(ALL)
Min. 1st Qu.
-508.40 23.72

Median
Mean 3rd Qu.
62.65
123.80 138.60

Max.
9422.00

PBV of Banks

> summary(PBV)
Min. 1st Qu. Median Mean 3rd Qu. Max.
0.6900 0.9975 1.8950 2.1920 2.5020 5.4400

Price Book Value Ratio: Stable Growth

Firm
P
E * b /( r g ) ROE * b

BV
BV
rg
g ROE * (1 b)

PBV

ROE * b ROE g
ROE g
rg
1
ROE g
1
PER

PBV
ROE
rg
ROE
PBV

PBV and ROE

PBV

PBV
1

ROE K e g

ROE

Retention
ratio
assumed to
be 25%

PBV Data for Indian Banks

Price to book and ROE: Indian banks

Call:
lm(formula = PBV ~ ROE)
Residuals:
Min
1Q Median
3Q Max
-1.1589 -0.7226 -0.3672 0.1583 3.5433
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -1.295
1.639 -0.791 0.4476
ROE
26.410
12.080 2.186 0.0537 .

PBV and Growth Rate: Indian Banks

Call:
lm(formula = PBV ~ Growth)
Residuals:
Min
1Q Median
3Q Max
-1.9852 -0.7997 0.1642 0.3107 2.9216
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -1.246
2.151 -0.579 0.575
Growth
15.683
9.640 1.627 0.135

PBV and CAR

Call:
lm(formula = PBV ~ CAR)
Residuals:
Min
1Q Median
3Q
Max
-1.87455 -0.53017 -0.01563 0.30955 1.72052
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -3.701
1.733 -2.135 0.05852 .
CAR
40.700
11.782 3.454 0.00618 **

PE or PBV?
lm(formula = PE ~ Growth + CAR + ROE)
Residuals:
Min
1Q Median
3Q
Max
-13.1556 -2.8970 0.7748 2.7099 13.4488
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -35.35
15.51 -2.279 0.0522 .
Growth
78.23
50.21 1.558 0.1578
CAR
284.50
90.36 3.148 0.0136 *
ROE
-51.94
76.67 -0.677 0.5172
--Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Residual standard error: 7.364 on 8 degrees of freedom
Multiple R-squared: 0.6362, Adjusted R-squared: 0.4998
F-statistic: 4.663 on 3 and 8 DF, p-value: 0.03627

Call:
lm(formula = PBV ~ Growth + CAR + ROE)
Residuals:
Min
1Q Median
3Q
Max
-1.57278 -0.38981 0.07051 0.40684 1.61755
Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -6.580
1.910 -3.445 0.00876 **
Growth
11.685
6.182 1.890 0.09542 .
CAR
32.242 11.126 2.898 0.01996 *
ROE
11.741
9.440 1.244 0.24880
--Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Residual standard error: 0.9067 on 8 degrees of freedom
Multiple R-squared: 0.7372, Adjusted R-squared: 0.6386
F-statistic: 7.479 on 3 and 8 DF, p-value: 0.01044

Equity- to - NAV Multiple

The net asset value is actually the present value of the cash flows that the
real estate company will generate from its existing land bank and other
operating activities (like rental income from leasehold land, etc.)

Assuming a 10% discount to

NAV, price will be Rs.27 per
share.

Price Sales Ratio: Definition

The price/sales ratio is the ratio of the market value of equity to the sales.

Issues

The price/sales ratio is internally inconsistent, since the market value of

equity is divided by the total revenues of the firm.

Even if the companies are unlevered, there may be leasing in the balance
sheet.

Even if there is no leasing, there may be lot of cash and cash does not
generate any sales.

PSR for a Levered and Unlevered

Company
Levered Company

Total Assets: $1000m

Debt: $600m

Equity: $400m

Total Sales: $2000m

PSR = 0.2

Unlevered Company

Total Assets: $1000m

Debt: $0m

Equity: $1000m
Total Sales: $2000m

The levered company looks undervalued.

PSR = 0.5

PSR for two unlevered companies

High Cash Unlevered

Total Operating Assets: $1000m

Total cash: $1000m

Equity: $2000m

Total Sales: $1000m

PSR: 2

Low Cash Unlevered

Total Operating Assets: $1000m

Total cash: $100m

Equity: $1100m
Total Sales: $1000m

Now the company having less cash looks undervalued!

PSR: 1.1

Price/Sales Ratio: Determinants

P P E P
Net _ Margin
S E S E
Key determinants:
Net Margin (m)
Growth rate (g)
Return on Equity (ROE)
Risk (r)

Reasons for Increased Use of

Value/EBITDA
1. The multiple can be computed even for firms that are reporting net losses,
since earnings before interest, taxes and depreciation are usually positive.
2. For firms in certain industries, such as cellular, which require a substantial
investment in infrastructure and long gestation periods, this multiple
seems to be more appropriate than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the firm
prior to all discretionary expenditures, the EBITDA is the measure of cash
flows from operations that can be used to support debt payment at least
in the short term.
4. By looking at the value of the firm and cashflows to the firm it allows for
comparisons across firms with different financial leverage.

Enterprise Value/EBITDA Distribution India

A Test on EBITDA

JK cements was trading at an EBITDA Multiple of 3.84 in 2011. Did that mean,
it wa an undervalued stock? What other factors could explain this low
multiple?

Ultratech cements was selling at an EBITDA multiple of 13.32. Did that give us
a selling opportunity?

JK Cements had its last major Capex five years back. Its plant required
modernization. Its ROIC was about 13%.

Ultratech had its last major capex done in 2008-09. Its ROIC is 19%.

Marginal tax rates were similar.

Terminal EBITDA Multiple

After the explicit forecasting

period, a company is supposed to
reach a steady-state stage.

Not much growth opportunities.

Hence high payout ratio.

Statistic

Value

Average

8.57

Median

7.93

Min

4.13

Max

14.25

Picking one Multiple

The multiple that is used can be chosen in one of two ways:

Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the highest
value.

Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc.
and run regressions of these multiples against fundamentals, use the
multiple that works best at explaining differences across firms in that
sector.

Use the multiple that seems to make the most sense for that sector, given
how value is measured and created.

A More Intuitive Approach

Managers in every sector tend to focus on specific variables when analyzing

strategy and performance. The multiple used will generally reflect this focus.
Consider three examples.

In retailing: The focus is usually on same store sales (turnover) and profit
margins. Not surprisingly, the revenue multiple is most common in this
sector.

In financial services: The emphasis is usually on return on equity. Book

Equity is often viewed as a scarce resource, since capital ratios are based
upon it. Price to book ratios dominate.

In technology: Growth is usually the dominant theme. PEG ratios were

invented in this sector.

Conventional Usage: A Summary