Your Company Is Worth As Much As Somebody Else Is Willing to Pay For It

Firm Valuation Using Market Multiples

There is a number of different market multiples that can be used for a quick valuation of the company. Some are relatively universal such as Price to Earnings ratio (P/E) and can be used in most sectors of the economy whereas others are more sector-specific such as EV/Proven Reserves used in the oil & gas industry. Market multiples can be either derived from the past stock market statistics of publicly traded companies and from market averages of their analysts' forecasts or from recent M&A transactions in the given sector. When defining an appropriate peer group, factors such as the economic sector, size of the company and the geographic location of its business should be considered. There is no single market multiple that can give you the most reliable comparative results so you should always use several metrics to get a more complete picture. The main weakness of this simplistic valuation approach is the quality of comparative data and their static nature.

Stock's Market Price-Based Multiples

P/E ratio also known as PER or earnings multiple is the most common indicator used across many industries. It compares the current market value of the company versus its net earnings (net profit) or, in other words, the current market value of one common share versus net earnings per share. As all other market multiples it can be calculated from historical earnings values as well as from forecasts but the market value of shares should be actual.

The higher the PER the more expensive the share and so the company is. At PER of 1x an investor would be buying its shares at one time its earnings, hence, he could buy the whole company from its annual net profit. At PER of 10x the investor is willing to pay ten times the net profit per share to acquire the shares in the company.

As mentioned earlier the main weakness of the valuation multiples is their static nature. Therefore, many investors favour PEG (Price/Earnings to Earnings Growth) ratios calculated as PER divided by the annual growth in net earnings per share. Low PEG ratios indicate that the stock is undervalued.

P/CE ratio (price to cash earnings) also dubbed as P/CF ratio (price to cash flow) or cash-earnings multiple compares the market value of the company versus the sum of net earnings and depreciation & amortization or, in other words, the market value of one common share versus cash earnings per share. Cash earnings may or may not also include amortization of intangible assets such as goodwill, depending on the individual analyst approach. Cash earnings tell you more about the cash generating ability of the company than simple earnings so this indicator should not be omitted when valuing industrial firms in the capital-intensive industries.

P/BV ratio (price to book value), also called P/NAV (price to net asset value), compares the market value of the company versus its own capital (BV = total assets - intangible assets - liabilities) and is most commonly used in the financial sector. It can also be interpreted as price per share to book value per share. High P/BV multiples may indicate high returns on assets and equity and expectations of fast earnings growth rate and thus faster growth in BV.

Other valuation multiples using the firm's current market value in their numerator include P/Sales, P/EBIT, P/EBITDA, P/OCF (operating cash-flow = EBIT + depreciation - taxes) as well as some sector specific metrics such as Price/Customer.

Some of the commonly used relative multiples using the company's current market value in their denominator include:

Gross Yield or Gross Dividend Yield compares the gross dividend per share (before deduction of taxes) versus the market value of the share or, in other words, the portion of the net profit that is distributed in dividends versus the market value of all outstanding shares. This is an important metrics in some industries with high dividend payout ratios such as energy utilities or telecoms.

Free Cash-Flow Yield is calculated as FCF (cash-flow from operations less total capex) to market capitalization. Alternatively it can be calculated by dividing FCF per share by the current market value of one common share. FCF yield is considered by many investors to be better representation of earnings that investor receives from owning the shares than dividend yield.

Enterprise Value-Based Multiples

EV/EBITDA ratio (enterprise value to earnings before interest, taxes, depreciation and amortization) also known as EBITDA multiple compares the enterprise value of the company, defined as the sum of its market value, minority interest and the net value of its bank debt (bank debt less cash and cash equivalents), versus EBITDA. This indicator takes into consideration not only the market value of shares but it also contains bank debt that the potential investor has to assume. It tells you more about the cash generating ability of the company than earnings or cash-earnings multiples and since it ignores taxes it can be used to compare firms from different countries. An inverted version of this ratio - EBITDA/EV is a good measure of the firm's return on investment and it is often preferred over simpler indicators such as RoE (net income on equity) as it takes into account differences in accounting, taxation and capital structure.

EV/EBIT ratio is similar to EV/EBITDA but less commonly used and it also values the company regardless of its capital structure. You can sometimes find an inverted version of this multiple - EBIT/EV - being used to measure the company's return on investment.

Other common multiples using the firm's enterprise value in their numerator include EV/Sales, EV/OCF, EV/DACF (debt-adjusted CF), EV/EBITDAR (where R stands for restructuring or rent costs), EV/IC (invested capital) as well as various sector specific metrics such as EV/Proven Reserves.

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