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Multiples
Multiples
CONFIDENTIAL
Corporate Finance
BUSINESS VALUATION
Document
Date Multiples
Using for Valuation
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circulated, quoted, or reproduced for distribution outside the client
organization without prior written approval from McKinsey & Company.
This material was used by McKinsey & Company during an oral
presentation; it is not a complete record of the discussion.
Session Overview
Unit of measure
1. Investigate what drives multiples and how to build a multiple that focuses
on the operations of the business
• Enterprise value multiples are driven by the drivers of free cash flow: return
Printed
1. Demonstrate why using the often-computed Price-to-Earnings ratio can be
PM6/24/2005 11:31:58 AM
misleading
• The P/E ratio is not a clean measure of operating performance. The ratio
commingles operating, non-operating, and financing activities
* Footnote 2
Source: Source
DCF vs. relative valuation
Unit of measure
DCF valuation
•Find the value of assets given their growth and
risk characteristics
Printed
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currently priced in the market
* Footnote 3
Source: Source
STOCK MARKET vs DEAL MULTIPLES
Unit of measure
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Acquisition premia
* Footnote 4
Source: Source
Use of relative valuation
Unit of measure
Printed
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• Can result in values that are too high when the
market is overvaluing comparable firms, or too low
when it is undervaluing these firms
• Lack of transparency regarding the underlying
assumptions
* Footnote 5
Source: Source
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
6
Assets-side vs Equity-side multiples
Source
Footnote
Unit of measure
Source:
*
Current, trailing, and leading multiples
Unit of measure
where:
E T0 = earnings per share generated in the last year
Printed
ELTM = earnings per share referring to the last 12 months (4 quarters)
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ET1 = earnings per share expected for the next year
* Footnote 7
Source: Source
Current, trailing, and leading multiples…
Unit of measure
EPS: MULTIPLE:
Printed
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YES NO
* Footnote 8
Source: Source
Back to Basics… What Drives Company Value?
Unit of measure
• To better understand what drives a multiple, let’s derive the enterprise value to
EBIT multiple using the key value driver formula.
g
EBIT(1 - T)1 −
Printed
Substitute EBIT(1-T)
ROIC
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The enterprise value
for NOPLAT Value = multiple is driven by:
WACC − g
(1) return on new
invested capital,
* Footnote 9
Source: Source
Back to Basics… What Drives Company Value?
Unit of measure
• Let’s use the formula to predict the multiple for a company with the following
financial characteristics.
g
(1 − T)1 −
Value ROIC
Printed
=
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EBIT WACC − g
5%
(1 − .30)1 −
Value 15% = 11.7
=
EBIT 9% − 5%
* Footnote 10
Source: Source
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
11
EV/EBIT (g=0)
Source
Footnote
Unit of measure
Source:
*
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
12
=
EV/EBIT (g>0)
Source
Footnote
Unit of measure
Source:
*
… EV/EBIT (g>0)
Unit of measure
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Excess return %
To understand the fundamentals, always start with a basic equity discounted cash flow
model.
With the dividend discount model,
Printed
EPS0 × Payout Ratio × (1 + g n )
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P0 =
r-gn
Reinvestm
ent needs
Finally:
P0 Payout ratio × (1 + g n )
= PE =
EPS0 r-gn
Risk Growt
* Footnote 14
Source: Source h rate
EV to EBITDA multiple
Unit of measure
Printed
WACC − g
PM6/24/2005 11:31:58 AM
D& A Reinvestment1
(1 − T ) − (1 − T ) −
EV0 EBITDA EBITDA
=
EBITDA WACC − g
* Footnote 15
Source: Source
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
16
=
P/BV (g=0)
Source
Footnote
Unit of measure
Source:
*
PBV ratio: stable growth firm
Unit of measure
DPS 1
Going back to a simple dividend discount model, P0 =
r − gn
= EPS0 / Book Value of Equity, the value of equity can be written as:
Printed
P0 =
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r-gn
* Footnote 17
Source: Source
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
18
EV/SALES (g=0)
Source
=
Footnote
Unit of measure
Source:
*
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
19
Multiples and leverage: P/E
Source
Footnote
Unit of measure
Source:
*
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
20
Multiples and leverage: EV/EBIT
Source
Footnote
Unit of measure
Source:
*
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
21
Multiples and leverage: P/BV
Source
Footnote
Unit of measure
Source:
*
Working Draft - Last Modified 7/1/2005 12:53:44 PM6/24/2005 11:31:58 AM
Printed
22
Unlevering the P/E
Source
Footnote
Unit of measure
Source:
*
Building Effective Multiples
Unit of measure
• A well-designed, accurate multiples analysis can provide valuable insights about a
company and its competitors. Conversely, a poor analysis can result in confusion. To
apply multiples properly, use the following four best practices:
Printed
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Step 1 Step 2 Step 3 Step 4
To analyze a Use an enterprise When building a Enterprise-value
company using value multiple to multiple, the multiples must be
comparables, you eliminate effects from denominator should adjusted for non
must first create an changes in capital use a forecast of operating items
appropriate peer structure and one profits, rather than hidden within
group. time gains and historical profits enterprise value and
losses reported EBITA
* Footnote 23
Source: Source
Step 1: Choosing Comparables
Unit of measure
1. Once a preliminary screen is conducted, the real digging begins. You must answer
a series of strategic questions.
Printed
• Why are the multiples different across the peer group?
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• Do certain companies in the group have superior products, better access to
customers, recurring revenues, or economies of scale?
• Harmonic mean: Compute the EBITA/Value ratio for each company and average
across companies. Take the reciprocal of the average.
* Footnote 24
Source: Source
Step 2: Use Enterprise-Value-to-EBITA Multiple
Unit of measure
Printed
EBITA EBITA
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• Consider a company that swaps debt for equity (i.e. raises debt to repurchase equity).
• Swapping debt for equity will keep the numerator unchanged as well. Note
however, that EV may change due to the second order effects of signaling,
increased tax shields, or higher distress costs.
* Footnote 25
Source: Source
Step 2: Use Enterprise Value Multiples
Unit of measure
Printed
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of an all-equity company
P K - PE u 1
=K+ where K =
E D kd
d
k ( PE u ) − 1
V
* Footnote 26
Source: Source
Price-to-Earnings Ratio: Why can it be Misleading?
Unit of measure
An Example:
• Before we use the formula to test the impact of capital structure on the P/E ratio,
let’s try an example.
Printed
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P K - PE u 1
=K+ where K =
E D kd
k d ( PE u ) − 1
V
* Footnote 27
Source: Source
Price-to-Earnings Ratio: Why can it be Misleading?
Unit of measure
• To show that the P/E ratio can be artificially impacted by a change in the company’s
capital structure, we use the formula to compute multiples for companies with
varying leverage ratios.
Printed
Increasing
PM6/24/2005 11:31:58 AM
Debt to 30% 8.2 13.5 20.0 28.0 70.0
Value
40% 7.5 12.9 20.0 30.0 120.0
* Assumes a cost of debt equal to 5% and no taxes: Therefore, 1/kd equals 20x.
* Footnote 28
Source: Source
Price-to-Earnings Ratio: Why can it be Misleading?
Unit of measure
Issue 2:
• The second problem with the P/E ratio is that it commingles operating and non-
operating performance. Each source can have vastly different financial
Printed
raises the P/E ratio.
PM6/24/2005 11:31:58 AM
• One time non-operating gains
EBIT
and losses such as restructuring
costs and other writeoffs will also
temporarily raise or lower earnings,
raising the P/E ratio. Most analysts
recognize this problem and make
necessary adjustments.
* Footnote 29
Source: Source
Step 3: Use Forward Looking Multiples
Unit of measure
• When building a multiple, the denominator should use a forecast of profits, rather than
historical profits.
Printed
Enterprise Value
PM6/24/2005 11:31:58 AM
therefore…
EBITA
EBITA = should represent FUTURE profit
• Research by Kim and Ritter (1999) and Lio, Nissim, and Thomas (2002) documents
that forward looking multiples increase predictive accuracy and decrease variance
of multiples within an industry.
* Footnote 30
Source: Source
Step 4: Adjust for Non-Operating Items
Unit of measure
Even the enterprise value-to-EBITA multiple commingles operating and nonoperating
items. Therefore, further adjustments must be made.
1. Excess cash and other non-operating assets have very different financial
Printed
PM6/24/2005 11:31:58 AM
2. The use of operating leases leads to artificially low enterprise value (missing
debt) and EBITA (lease interest is subtracted pre-EBITA). Although operating
leases affect both the numerator and denominator in the same direction, each
adjustment is of different magnitude.
* Footnote 31
Source: Source
Step 4: Adjust for Non-Operating Items
Unit of measure
3. When companies fail to expense employee stock options, reported EBITA will
be artificially high. Enterprise value should also be adjusted upwards by the
present value of outstanding stock options.
Printed
4. To adjust enterprise value for pensions, add the present value of unfunded
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pension liabilities to debt plus equity. To remove gains and losses related to plan
assets, start with EBITA, add the pension interest expense, and deduct the
recognized returns on plan assets.
* Footnote 32
Source: Source
Building a Clean Multiple: An Example
Unit of measure
Printed
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2005 EBITA 8,691 4,589
enterprise-value multiple is
Implied interest from leases 340 154
within 7 percent of that for
Adjusted 2005 EBITA 9,031 4,743
Lowe’s. After adjustments,
the difference drops to 5
Home Depot Lowe’s
percent.
Raw enterprise value multiple 8.7 9.3
* Footnote 33
Source: Source
An Examination of Alternative Multiples
Unit of measure
Although we have so far focused on enterprise-value multiples based on EBITA , other
multiples can prove helpful in certain situations.
Printed
PM6/24/2005 11:31:58 AM
enterprise multiple, because it allows expected growth to vary across companies.
* Footnote 34
Source: Source
Alternate Multiples: Price-to-Sales Multiple
Unit of measure
Enterprise/Sales
Printed
Enterprise/EBITA
PM6/24/2005 11:31:58 AM
Price/Earnings
0 15 30 45 60
• Applying the enterprise value to sales multiple from various retailers to Home Depot
revenue would estimate its “fair” stock price somewhere between $4 and $60, too
wide to be helpful.
* Footnote 35
Source: Source
Alternate Multiples: PEG Ratios
Unit of measure
Printed
Home improvement
PM6/24/2005 11:31:58 AM
by its EBITA growth rate (11.8%).
Home Depot 7.1 11.8 0.60
Lowe’s 7.3 17.2 0.42
Home furnishing
Bed Bath & Beyond 9.9 16.1 0.61 Based on the enterprise-based
Linens ’n Things 5.1 15.4 0.33 PEG ratio, Bed Bath & Beyond
trades at a significant premium to
Linens ‘n Things.
* Footnote 36
Source: Source
Alternate Multiples: PEG Ratios
Unit of measure
1. There is no standard time frame for measuring the growth in profits. The valuation
analyst must decide to use one year, two year or long term growth.
Printed
15
presented in the graph (the
PM6/24/2005 11:31:58 AM
dotted line). As growth 10
• Many financial analysts use multiples of EBITDA, rather than EBITA, because
depreciation is a noncash expense, reflecting sunk costs, not future investment.
• But EBITDA multiples have their own drawbacks. To see this, consider two
• What is each companies EV to EBITDA multiple and why are they different?
Printed
PM6/24/2005 11:31:58 AM
Comp A Comp B
Revenues 100 100 Company B outsources
Company A
Raw materials (10) (35) manufacturing to
manufactures
another company
product with their Operating costs (40) (40)
own equipment EBITDA 50 25 Incurs depreciation cost
indirectly through an
Incurs depreciation
increase in the cost of
cost directly Depreciation (30) (5) raw material)
EBITA 20 20
* Footnote 38
Source: Source
Alternative Multiples: EV to EBITDA
Unit of measure
• Because both companies produce identical products at the same costs, their
valuations are identical ($150). Yet, there EV/EBITDA ratios differ. Company A
trades at 3x EBITDA (150/50), while Company B trades at 6x EBITDA (150/25).
Printed
Enterprise value/EBITA 7.5 7.5
PM6/24/2005 11:31:58 AM
• When computing the enterprise-value-to-EBITDA multiple, we failed to recognize
that Company A (the company that owns its equipment) will have to expend cash to
replace aging equipment.
• Since capital expenditures are recorded as an investing cash flow they do not
appear on the income statement, causing the discrepancy.
* Footnote 39
Source: Source
Multiples on Non-Financial (Operational) Data
Unit of measure
• Multiples based on nonfinancial (i.e. operational) data can be computed for new
companies with unstable financials or negative profitability. But to use an
operational multiple, it must be a reasonable predictor of future value creation, and
• Many analysts used operational multiple to value young Internet companies at the
beginning of the Internet boom. Examples of these multiples included:
Printed
PM6/24/2005 11:31:58 AM
Website Hits Number of Subscribers Unique Visitors
2. Non-financial multiples, like all multiples, are relative valuation tools. They do
not measure absolute valuation levels.
* Footnote 40
Source: Source
Closing Thoughts
Unit of measure
A multiples analysis that is careful and well reasoned will not only provide a useful check
of your DCF forecasts but will also provides critical insights into what drives value in a
given industry. A few closing thoughts about multiples:
2. A well designed multiples analysis will focus on operations, will use forecasted
Printed
profits (versus historical profits), and will concentrate on a peer group with similar
PM6/24/2005 11:31:58 AM
prospects.
* Footnote 41
Source: Source