Market-Based Valuation: Price and Enterprise Value Multiples

Learning Outcome Statements

d. calculate and interpret alternative price multiples and dividend yield;

e. calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

f. explain and justify the use of earnings yield (E/P);

g. describe fundamental factors that influence alternative price multiples and dividend yield;

h. calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

i. calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

j. evaluate a stock by the method of comparables, and explain the importance of fundamentals in using the method of comparables;

k. calculate and interpret the P/E-to-growth ratio (PEG), and explain its use in relative valuation;

l. calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

m. explain alternative definitions of cash flow used in price and enterprise value (EV) multiples, and describe limitations of each definition;

n. calculate and interpret EV multiples, and evaluate the use of EV/EBITDA;

CFA Program Curriculum, 2015, Volume 4

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Learning Outcome Statements

d. calculate and interpret alternative price multiples and dividend yield;

e. calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

f. explain and justify the use of earnings yield (E/P);

g. describe fundamental factors that influence alternative price multiples and dividend yield;

h. calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

i. calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

j. evaluate a stock by the method of comparables, and explain the importance of fundamentals in using the method of comparables;

k. calculate and interpret the P/E-to-growth ratio (PEG), and explain its use in relative valuation;

l. calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

m. explain alternative definitions of cash flow used in price and enterprise value (EV) multiples, and describe limitations of each definition;

n. calculate and interpret EV multiples, and evaluate the use of EV/EBITDA;

Subject 9. Enterprise value / EBITDA ratio

Since EBITDA are distributed between all types of investors in the company (common shareholders, preferred shareholders and creditors), it reflects the fundamental value of the company as a whole. Therefore, a multiple using total company value is logically more appropriate. EV/EBITDA ratio responds to this need.

Enterprise value (EV ) is total company value minus the value of cash and investments.

EV = MV of common stock + MV of preferred stock + MV of debt — cash and investments

EV/EBITDA is an indication of company value, not equity value.

Example

• Net income: 34.0.
• Interest Expense: 7.62.
• Cash outflow for interest payments: 4.0.
• Depreciation and Amortization: 17.2.
• Marginal tax rate: 25%.
• Cash and marketable securities: 8.9.
• Investments: 6.2.
• Price per common share on the Paris Stock Exchange: 13.8.
• Total number of shares issued: 20,000,000.
• Total number shares in treasury stock: 1,320,000.

The company’s financials show that the only interest-paying liability assumed by the company is a 5-year $200MM note maturing in 3 years’ time and currently trading at 4.13%. The note is paying semiannual coupons and all interest payments have been met so far.

The company also has preferred stock that is not trading on any exchange. The book value of preferred stock is $45. No preferred dividends are currently in arrears.

Solution:

1. Calculation of EBITDA

EBITDA = Net Income + Interest Expense + Depreciation and Amortization + Tax Expense.

Tax Expense = (Net Income / (1 — Tax Rate)) — Net Income = [34.0 / (1 — 0.25)] — 34.0 = 11.3.

EBITDA = 34.0 + 7.62 + 17.2 + 11.3 = 70.12.

2. Calculation of Enterprise Value (EV)

Total market value of common stock = price per share of common stock x number of shares outstanding = Price per share x (shares issued — treasury stock) = 13.8 x (20,000,000 — 1,320,000) = 257.7 MM

Since the company’s preferred stock is not publicly traded, we will use its book value for calculation of EV.

Semiannual coupon on the bond = Cash Outflow for Interest Payments / 2 = 4 / 2 = 2.

We know the bond’s term to maturity = 3 years.

Yield to maturity = 4.13%.

Semiannual coupon payments = 2MM.

Face Value = 200MM.

Therefore, we can calculate the bond’s total current market value = $188.1.

EV = Total market value of common stock + Total market value of preferred stock + Total market value of debt — Cash balances — Investments = 257.7 + 45.0 + 188.1 — 8.9 — 6.2 = 475.7.

3. Calculation of EV/EBITDA ratio

EV/EBITDA = 475.7 / 70.12 = 6.78

Advantages:

• EBITDA is more often positive than net income.
• By adding back depreciation and amortization, EBITDA is invariant to the depreciation method used. EV/EBITDA ratio is often used for valuation of capital-intensive companies.
• It is more appropriate than P/E for comparing companies with different financial leverage, since EBITDA is not influenced by interest expense.

Disadvantages:

• When capital expenditures do not equal the depreciation, EBITDA is not a technically correct proxy to cash flow. This qualification to EBITDA comparisons can be meaningful for the capital-intensive businesses to which EV/EBITDA is often applied.
• EBITDA does not account for changes in the working capital, which makes it even more distinct from the correct cash flow definition.
• EBITDA includes non-cash revenues due to the accrual accounting principle.

Valuation Based on Forecasted Fundamentals

The fundamental drivers of EV/EBITDA are the expected growth rate in free cash flow to the firm and the weighted average cost of capital. The justified EV/EBITDA based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second.

Valuation Using Comparables

• Firm EV/EBITDA benchmark: overvalued.

Example

Fox Entertainment has the highest multiple due to its near-average growth and the lowest risk among the four compared companies. Disney demonstrates even lower growth, essentially the same level of risk as Fox, and consequently trades at the lowest multiple among the comparables. Viacom seems to be overvalued relative to AOL Time Warner: both companies have beta around 1.4, very close growth rate about 16%, but based on the leading EV/EBITDA AOL Time Warner is trading with 10/15.8 — 1 = 37% discount to Viacom.