Price to What? Making Sense of Valuation Multiples
Valuation multiples are arguably the most frequently used business valuation tools, and with good reason. They are quick to calculate, comparable across companies, and relate fundamentals to prices – all with minimal complexity.
But like many shorthand tools, valuation multiples are frequently misused in practice. Writers argue about undervalued banking and insurance stocks based on low price to earnings ratios even after large onetime gains. Analysts invent new multiples as times change, sometimes intelligently, and sometimes missing the mark entirely - think back to valuation multiples during the dot-com bubble comparing eyeball counts to stock prices.
This paper provides a framework for choosing which multiple to use in which circumstance. The choice depends on the economic truism that the value of the asset is equal to the discounted value of its future cash flows. With that in mind, a proper valuation multiple should adhere to the following principle:
The fundamental metric in the multiple should be the one that best predicts future cash flows attributable to the asset being valued.
This sounds simple, and it is in theory. But its application is not. There are two parts to the statement, and both can be tricky.
Part one is that the fundamental metric should best predict future cash flows. Finding this metric is no easy feat when so many metrics are available. Below we go through the most common metrics and suggest certain business models that fit with each metric.
Part two is that the fundamental metric's cash flows should be matched with the asset. This is obvious when valuing an asset like a bond. All coupon payments are attributable to the bond itself. It is similarly easy when a stock is 100% equity financed. However, companies with mixed capital structures - preferred shares or debt in addition to common stock equity - are more complicated. We touch on these issues when we discuss enterprise value multiples in Section 3.
The following 2 x 2 matrix shows the two key considerations when choosing a proper valuation multiple:
The paper is structured as follows:
Section 1: Covers asset multiples for common stocks (the top left quadrant of the matrix) including Price to Book Value, Price to Tangible Book, etc.
Section 2: Covers flow multiples for common stocks (the top right quadrant of the matrix)
Section 2.1 Covers accrual accounting multiples including Price to Earnings, Price to Sales, etc.
Section 2.2 Covers cash accounting multiples including Price to Cash Flow, Price to Free Cash Flow, etc.
Section 3: Covers enterprise value multiples (the lower half of the matrix) including EV to EBITDA, EV to Revenues, etc.
Section 4: Briefly discusses business driver multiples - multiples based on non-financial metrics
The downloadable pdf linked at the top and bottom of this article also provides a summary table of 16 common valuation multiples and their use cases.
Section 1: Asset Multiples: When Observed Assets Best Predict Future Cash Flows
This category of stock is one with steady long-term average return on accounting assets, specifically Return on Equity (ROE). Banks, insurance companies, and closed-end funds are the clearest examples in this category. The business model in this case is straightforward. Assets are invested and earn a specific long-term average rate of return.
Book Value of Equity x Expected ROE ≈ Expected Future Cash to Common (1)
In any given year, market conditions will affect the returns to banks' and funds' investments in securities. Unforeseen disasters will hurt property and casualty insurers' bottom lines. However, over the long-run, good years and bad years average out , and these firms should earn a reasonable average rate of return on their investments. All else equal , the firm with the most investable assets will earn the largest cash return on that investment.
Given that firms can earn returns on all their assets, one might expect Price to Assets to be an excellent valuation metric, and it is when a firm is 100% financed by common equity holders. However, when a firm also uses debt or preferred equity to finance its operations, those stakeholders have a claim on assets and cash flows as well. Thus, the equity investor must subtract other stakeholders’ claims from the total value of the firm when determining the market capitalization of the company (and hence the price of the common stock). And to ensure that market cap is matched to equity holders’ claims on assets in a valuation multiple, common stock investors must use book value of equity or something similar, which represent only common shareholders’ claims on assets.
It's also important to note that that major changes to the financing structure of a company can affect equity holders' future cash returns, so an investor should be mindful of the effect of changing financial leverage when using asset based multiples.
The most common asset-based multiples are summarized here in Table 1.
Section 2: Flow Multiples: Observed Earnings Best Predict Future Cash Flows
This category of stock is one where values of assets on the balance sheet have little correlation with earnings over time.
Businesses where assets do not predict future earnings are easy to uncover these days. An example is IBM, where the vast majority of the economic assets of the company are in its relationships, processes and knowledge, which are not easily accounted for on the balance sheet. Because key assets are not noted on the balance sheet, asset multiples can look unreasonable when compared to businesses where the majority of productive assets are included in the balance sheet.
Mathematically, this is a situation where equation (1) does not apply, and should be replaced by:
Normalized Cash Flows x (1 + G)T ≈ Future Cash to Common Stock (2)
There are two tricky pieces to this equation. The first is "Normalized Cash Flows" and the second is the “G” for growth (“T” is time). We defer to others on growth rates, since thoughts on them could fill a whole book, and turn our attention to Normalized Cash Flows, looking first at accrual accounting multiples - Price to Sales, Earnings, etc. - and then at cash accounting multiples - Price to Cash Flow, Free Cash Flow, etc.
Section 2.1: Accrual Accounting Multiples
Accrual accounting multiples are the default multiples that most practitioners use - Price to Earnings Ratio is the most common. These multiples are most appropriate when accrual accounting methods do a good job smoothing short-term fluctuations in cash flows and there has been no recent onetime shock to earnings.
Cash flows can diverge from earnings for any number of reasons, but the most common are 1) investments in assets like property, plant and equipment or inventory which are purchased up front but used (and expensed via depreciation) over time, and 2) revenue recognition practices where cash is collected in periods other than when revenue is recognized. Examples of the second case include subscription business where businesses collect cash up front but recognize revenue over time and long-term contract businesses like aircraft manufacturers that use a "percentage of completion" method to recognize revenue even when cash is paid in installments that often bear no relationship to revenue recognition.
Over the long term, earnings and cash flows available to common shareholders must converge, but over the short term, cash flows tend to be more volatile than earnings.
Each of the metrics in Table 2 is a different way of getting at Normalized Cash Flows via accrual accounting methods. The table describes how each differs from the other.
Section 2.2: Cash Accounting Multiples
Earnings have two features that make them more attractive fundamental metrics for price-based valuation multiples than cash flows under many circumstances: 1) they smooth out short-term fluctuations in cash inflows and outflows, and 2) by definition, they exclude all cash flows that "belong" to non-common shareholders, such as interest payments to debt holders and preferred stock dividends. Since the stock price represents the value of common stock, earnings and price are directly comparable. Cash flows are not always similarly comparable because they can represent cash available to all stakeholders, not just common shareholders.
That said, cash flows are more attractive to an investor than earnings because they cannot be easily manipulated whereas earnings can easily be massaged using varying interpretations of accounting rules. With this knowledge in mind, investors will often use current cash flows to predict future cash flows when 1) they believe that current cash flows are a good estimate of normalized future cash flows and 2) they have reason to believe that earnings numbers might be misleading due to legal, but unreasonable, accounting practices.
Mathematically, this is a situation where neither equations (1) or (2) apply, and should be replaced by:
Normalized Cash Flows x (1 + G)T ≈ Future Cash Flow to All Stakeholders (3)
Again we defer to other sources for a discussion of growth and focus on the different versions of "Normalized Cash Flows" in Table 3 below.
When dealing with cash flow multiples, pay close attention to whether the cash flow figure in the multiple includes or excludes cash that debt or preferred stock holders could receive before common shareholders. We want cash flows available to common shareholders only, because we are comparing these flows to the price of common shares. Also be sure that the cash flow figure accounts for depreciation expenses (see our note on valuation multiple gotchas for more detail).
Section 3: Enterprise Value Multiples
Enterprise value multiples are similar to price multiples, except they are most commonly used by investors engaged in the purchase or sale of entire businesses - leveraged buyouts funds, venture capitalists, acquisitive public companies, and their advisors are examples.
Because enterprise value represents the value of the business to all stakeholders, the fundamental metric should approximate normalized cash flow to all equity and debt holders. This is the only substantive economic difference between enterprise value and price based multiples.
As a result, the same principles that apply to flow versus asset multiples for stock prices apply to flow vs. asset multiples for enterprise value. When assets are invested at a reasonably constant Return on Assets (ROA), asset metrics can and should be used in the denominator. When asset growth correlates poorly with cash flow growth, flow metrics should be used.
Arguably the best multiple for asset driven businesses is EV / Assets. This is because all cash earned by investing all assets on the balance sheet is available to pay stakeholders.
For flow driven businesses, the most common multiples used in practice are EV / EBITDA and EV / EBIT (see the table below for the definitions of EBITDA, EBIT, and EBITA). Though they are the most common multiples, there is a persuasive case that EV / EBITA is in fact the most reasonable multiple to use in enterprise value analysis.
EBITA succeeds in areas where the other two metrics fail. Both EBIT and EBITDA rightly look at earnings before interest is paid - under the assumption that the enterprise owner holds debt and will collect those interest payments. They also rightly look at earnings before taxes to smooth out any one-time gains or losses due to taxes.
However, EBIT allows amortization expenses, which are legally required non-cash expenses that do not necessarily have any economic meaning and should be ignored. EBITDA ignores a very real expense - depreciation - that is necessary for most businesses to continue operations. Investors certainly cannot withdraw cash from a business that is earmarked for the purchase of depreciable assets (new buildings, machinery, computers, etc.) without seriously affecting the future value of the business.
This leaves EV / EBITA as the multiple that makes the most sense when valuing an entire business and current flows best predict future flows.
Common enterprise value multiples are summarized in Table 4 below.
Section 4: Business Driver Multiples - A Brief Discussion
Business driver multiples compare market cap or enterprise value numbers to some non-financial metric. Examples include EV to Proven Reserves for oil & gas companies and EV per Square Foot in retail.
We mention these metrics only briefly to point out that they do exist and that they must be evaluated on a case-by-case basis. Some are excellent and some are unreasonable. To evaluate them properly, just test them against the key principle from the introduction:
The fundamental metric in the multiple should be the one that best predicts future cash flows attributable to the asset being valued.
If the business driver multiple adheres to the principle, it is legitimate. Otherwise, it should probably be avoided.
Note: For a list of business driver multiples, see the book Investment Banking: Valuation, Leveraged Buyouts and Mergers and Acquisitions by Rosenbaum and Pearl.
In this paper we have covered the most common categories of valuation multiples and provided a framework for choosing which type of multiple to use in which circumstance. As is usual in the case of financial topics, hard and fast rules rarely cover every situation. Exceptions abound. However, we hope that the framework provided is helpful to quickly narrow the list of multiple choices so hard effort can be focused on getting inputs right.
Nathan Pinger is YCharts’ Product Manager. His analysis has been quoted in Forbes and the New York Times. An investor since his mid-teens, he holds an MBA with High Honors from the University of Chicago Booth School of Business and BAs in Mathematics and Economics from the University of Wisconsin-Madison, where he graduated Phi Beta Kappa.
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