The Market Approach to Valuation

The Price-to-Earnings (P/E) Multiple The Market Approach often applies a Price-to-Earnings (P/E) multiple from a comparable company to derive an unknown price P*, of a company whose Earnings (E*) are either trailing (already known, in the past) or forecasted for the coming year. By using the known Price, Earnings, and hence, P/E ratio, of a comparable, public company, one can solve for the unknown P*, where P* = E* x (comparable P/E). If, for example, the company whose Price is in question has forecasted earnings of 10 in the coming year, and a competitor in the exact line of business is trading at Price equal to 7.5 x 12 months trailing earnings, our unknown price would be: P* = 10 x (7.5) P* = $75/share When multiplied by the number of shares outstanding, say 1 million, you get a market capitalization of $75 million. That is, a total equity value of $75 million. However, while widely used, P/E is fraught with caveats P/E ignores the time value of money. A higher P/E ratio means that investors are paying more for
each unit of net income. The P/E ratio can be interpreted as "number of years of earnings to pay back purchase price", ignoring the time value of money.

P/E ratios tend to use historical data. The comparative Earnings are generally last years, which is
not a sound basis for future earnings of the company in question.

The P/E Ratio can be artificially impacted by a change in capital structure. Even when there
is no change in overall company value, a capital structure the relies more heavily on debt presents a large interest burden (and hence lower earnings) for a company. However, in theory, a companys value should not depend on its capital structure.

The P/E Ratio ignores debt. When valuing an unknown company to another using P/E, the resulting
valuation says nothing about debt. It merely estimates P, or market price of equity, of the unknown. But debt can and very often is a large component of a companys overall value. Thus P/E falls short of painting an accurate picture of company value.

Earnings can be easily manipulated. Earnings is an accounting figure that includes non-cash items.
Furthermore, Generally Accepted Accounting Principles (GAAP) laws change over time and between countries. Rare is a P/E comparison that is truly apples-to-apples, even for firms in the exact same business.

Earnings commingles operating and non-operating performance. Any Earnings (i.e. Net
Income) figure encompasses Operating (e.g. Sales), Investing (e.g. Depreciation), and Financing (e.g. Interest payments), not to mention taxes. Using it as a direct medium of comparison is fraught with potential red herrings.

The EV-to-EBITDA (Enterprise) Multiple As an alternative to the P/E ratio, many finance professionals use the Enterprise Multiple when attempting to price a company of unknown value. In doing so, rather than compare Price to Earnings, they compare a companys Enterprise Value (market value of Debt + Equity - cash), to its pre-depreciation, pre-tax, pre-interest operating income (EBITDA).

It is important to note that the value of a company should not be affected by its capital structure. Equity alone, debt alone, or some combination of the two, are merely claims by different investors on the assets a company has and will produce in the future. Varying claims say nothing about the companys operations, the value of its underlying assets, their potential to generate returns, or the growth prospects of the company. And so it can be said that differing capital structures do not in and of themselves affect the underlying value of a company. Why not just compare EV to Earnings, as we do with Price in the P/E ratio? For one, by using EV instead of just P in the numerator, we have added debt back. We must act accordingly in the denominator, adding the effects of debt (the interest payments) back into the Earnings figure, so we would end up with something like EV / EBIT. This introduction of interest back into the denominator serves a dual purpose, however. Companies with debt, and therefore interest payments, receive a tax writeoff for the interest payments. So the interest expense lowers earnings slightly, while the tax writeoff raises earnings slightly less. Comparing two otherwise identical companies using only Earnings (i.e. Net Income) would not account for these two differences. By comparing Earnings before the effects of interest (i.e. EBIT), we eliminate the varying effects of both interest payments and taxes on underlying asset value. Remember, we said the two companies were otherwise identical. A different capital structure should notand does not, using EBITwarrant a different valuation. Why, then, do we use EBIT before depreciation and amortization (EBITDA) in our comparison ratio? In a given year, it is highly unlikely both companies will be at the exact same point in their depreciation schedules. This is not to say that the companies we are comparing have different levels of capital expenditures. But because otherwise comparable companies can have drastically different depreciation amounts and schedules at any given time, we remove this factor from our comparison ratio for an even more apples-to-apples comparison. Revenue multiples, such as EV/Sales, are sometimes used because a Sales figure can be easier to come by than an EBITDA figure. In addition, EV/Sales can be applied to companies that are not yet profitable. However, revenue multiples ignore profitability, which is always a critical value driver. In addition, using an EV/Sales multiple to compare two companies makes the inherent assumption that the companies have similar operating margins (i.e. Earnings after taking into account Operating or Overhead Expenses). This is hardly ever the case, and would be an overly burdensome restriction on our use of a comparison ratio. Therefore, for a valid comparison, we must travel down the Income Statement a little further for a point of comparison (i.e. EBITDA) with a more standard relationship to Enterprise Value than Sales alone can usually offer. For this reason, the EV/EBITDA multiple is superior, though it requires prudent use for companies with low profit margins but high EBITDA margins. The Enterprise Multiple is preferable to a Sales or Earnings multiple for several reasons: It's useful for transnational comparisons: EV/EBITDA ignores the distorting effects of individual
countries' taxation policies.

It's used to find attractive takeover candidates: Enterprise value is a better metric than market
capitalization (i.e. equity value) for takeovers. It looks at the value attributable to the companys debt, which the acquirer will have to assume.

It can be more readily compared across companies with different capital structures.
However, Enterprise Value can vary depending on the industry. It's important to compare the multiple to other companies or to the industry in general.

A low EV/EBITDA ratio relative to a companys peers may indicate that a company is overvalued. Higher growth companies (e.g. software) trade at an EV/EBITDA of perhaps 15-20x, while more mature

and asset intensive industrial companies (e.g. railcar manufacturing) trade at around 8-12x. To illustrate the superiority of EV/EBITDA over P/E, consider two competitors of similar size and profitability. They have similar Enterprise Values (EV). However, if the first business has more debt, then value of its equity would be lower. Hence, if the P/E ratio were used to compare the two, one might erroneously conclude that the first business is fundamentally more valuable than its competitor (since it has a lower denominator relative to the numerator). Using EV/EBITDA avoids such problems associated with differences in financial leverage. Enterprise Multiples can then be applied to the financials of the company being valued. If these two competitors are trading, on average, at EV/EBITDA of 10x and the unknowns EBITDA is $15MM, then its implied EV is $150MM. To estimate its implied Equity Value (i.e. market capitalization), one would have to subtract the value of its debt and add its cash to the $150MM. Note that multiples are typically applied to normalized numbers that exclude one-off items and items that would not continue if the company were acquired by new owners (generous executive perks, corporate jets, etc.). More on Enterprise Value EV refers to the aggregate value of a company, as opposed to its market capitalization. Market Cap is a companys price tag. Enterprise Value, in contrast, adds in the Net Debt. It equals Market Cap plus Debt, minus the amount of cash the company has (which in theory could go to pay down that amount of debt immediately). Why is Debt considered in valuing a firm? A new owner who takes over the company must pay off its shareholders, but is also responsible for whatever debt the company has. To illustrate, two companies with equivalent market caps both have assets procured through equity financing. If one of those companies has debt, it has the assets procured by debt financing as well. So the value of its non-cash Assets, or its Enterprise Value, will be higher, and the company is worth more, although it is also true that the debt must be serviced with interest payments, and paid back according to its covenants. Thought of another way, any cash that comes with a sale is extraneous to the transaction, and so is deducted from the Enterprise Value calculation. If you purchased a $200,000 sports car that had a few payments remaining, and it came with a suitcase in the trunk containing $50,000, you really only paid a net of $150,000 for it, and you have to finish making the payments. If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay more than $250 if he or she were to buy the company's entire stock, as share price would get bid up until the total cost was closer to $400. While the buyer has to assume $150 in debt, bear in mind that long before the buyout, debt has been procured to increase the assets in the company beyond the value of what the stockholders put in, thus increasing the value of the company, and making any assessments that take only the spot equity value (i.e. the value of the stock price) into account preliminary at best. More on EBITDA An EV/EBITDA calculation is useful as an apples-to-apples comparison between companies. This ratio has a much greater likelihood of commonality between two companies that are in the same lines of businesspeers, so to speak. In the end, an Enterprise Multiple valuation is only as strong as the availability of good peers with which to compare. EBITDA reflects a companys earnings before taking into account:

Payments that service debt of any particular size (i.e. Interest expense) Taxes, which can vary dramatically between even the most similar companies, due to the potential of tax loss carry-forwards, deferred taxes, and other unique factors Depreciation and Amortization, which are noncash expenses used to divide the total cost of big purchases into smaller portions, payable over multiple years after asset delivery

Whats left of EBITDA are the profit or loss after Cost of Goods and Overhead. These earnings will be of similar proportion to the companys total value as those of an appropriately-constructed peer group of similar firms. If we compared companies by their EV-to-Earnings (i.e. Net Income) ratios, we would be considering the widely varying effects of many factors that obscure the results of operations and potential growth. So by comparing companies by the ratio of their Enterprise Values to their Earnings Before Interest, Taxes, Depreciation, & Amortization, we control for capital structure, interest payments on debt with a near-infinite number unique terms and conditions, non-cash expenses set by potentially widely-varying depreciation schedules, and tax burdens unique to every company. Furthermore, EBITDA is a much closer approximation of a companys free cash flow in a given period than is Net Income. And cash flow is what investors care about the mostas is evident by the use of the Discounted Cash Flow approach to valuation.

The Income Approach to Valuation

The Discounted Cash Flow (DCF) Analysis Unlike the Market Approach, which involves comparing Enterprise Multiples of similar, publicly-traded companies, or using multiples from recent acquisitions (or financings) of comparable companies, the Income Approach analyzes the specific economics and prospects of the subject company itself, without direct comparison to other businesses. While a DCF analysis has the benefit of not relying on comparisons (which are never perfect), this method is more complicated and time-consuming. Furthermore, in practice the subjective nature of the projections required to calculate DCF are considered a drawback to consistency and reliability. A DCF analysis is only as good as the quality and reliability of the financial projections it uses. By the same token, however, a robust DCF analysis can provide unique insight into the specific value drivers of a business, and can highlight the impact of different sets profitability assumptions. Furthermore, DCF projections involve the pricing of all manner of growth assumptions (both revenue and expense) into a companys value. These assumptions are absent from the Market Approach to valuation. Unless the compared companies are at the same stage of development, a direct comparison to other businesses can never be apples-to-apples. A valuation exercise that includes both the Market and Income Approaches can provide an integrated perspective on value. The Time Value of Money Not all dollars are created equal. Money has a time value. That is, a dollar today is worth MORE than a dollar tomorrow. Why? Because a dollar today can be invested to produce a return. For example, if you put a dollar in a bank account that pays 10% per annum, it will return $0.10 when you retrieve it one year from now. Your balance will be $1.10. If you leave it for another year, both your $1.00 and your $0.10 return will BOTH earn a return: $0.10 and $0.01, respectively. Your account after two years will be ($1.00 + $0.10) + ($0.10 + $0.01) = $1.21. This can also be expressed as: Initial investment + (return after 1st year) + (return after 2nd year) = $1.00 + (10% * $1.00) + (10% * $1.10) = $1.00 x (1+10%)2 In other words, the Future Value is equal to: Initial investment * (1 + rate of return)(number of periods) This equation works backwards or forwards, for any number of periods. For example, if you wish to know what some future value would be worth in todays dollars (in other words, the Present Value), you can flip the equation around. Substituting the term present value for initial investment, the formula would be: Present Value = Future Value / (1 + rate of return)(number of periods) If you are to receive $1.33 in 3 years, the Present Value equals: $1.33 / (1+10%)3 = $1.33 / (1.1) * (1.1) * (1.1)

= $1.33 / 1.33 = $1.00 In financial terms, you are INDIFFERENT between receiving $1.00 now, $1.10 in a year, $1.21 in two years, or $1.33 in three years, given that your time value of money is 10% (per year). The Cash Machine Analogy Imagine a machine that spits out a predictable amount of cash, once a year. How much would you pay for such a machine? Without additional information, it is impossible to say. What about if the amount the machine spits out is $5.00 per year, for five years, and then shuts down? Certainly not $25.00, since that doesnt account for the time value of money. And what if the time value of money, a.k.a. your Cost of Capital, is 10%? Now were getting somewhere. From our equation, the Present Value of the money is: $5.00 / (1+10%)1 + $5.00 / (1+10%)2 + $5.00 / (1+10%)3 + $5.00 / (1+10%)4 + $5.00 / (1+10%)5 This computes to $18.95 a far cry from $25.00. Why is the number so much lower? Because the machine pays out annually over the course of five years, and not immediately. If you were offered an opportunity to purchase the machine for $18.00, you would do so, because it would provide you with $18.95 in todays dollars. If the machine were offered to you for $19.00, you would be overpaying for it, since its present value is lower. We can amend our equation to describe the Present Value of any such machine: For all periods, the sum of: Cash Flow / (1 + Cost of Capital) (period) What if the machine doesnt shut down after five years, but continues to spit out $5.00 per year, forever? Such an arrangement is called an Annuity. Leaving the complicated math to the professionals, we know we can reduce our equation to something incredibly simple: Present Value of an Annuity = Cash Flow / Cost of Capital. Thats it! So what would we pay for a machine that spits out $5.00 a year, forever? Considering our cost of capital is 10%, the answer is $5.00 / 10%, or $50.00 exactly. No more, no less. Substituting the notion of a machine for that of a company, we can use this Discounted Cash Flow methodology to estimate the value of a company. All we need are accurate estimates of 1) The companys Cost of Capital, and 2) The amount of cash we expect the company to generate each year for the foreseeable future. Neither estimate is easy. Hundreds of books and entire graduate courses are dedicated to the process of estimating a given companys Cost of Capital. We generally make an educated guess based on a number of knowable factors. As for the Cash Flow estimate, we typically estimate between 5 and 10 years worth (the number need not be the same each year), and add on a Terminal Value, using the Annuity Formula, to represent all cash flows from the end of our estimate, off into infinity. Of course, the Terminal Value itself has to be discounted into todays dollars, too. Given the time value of money, however, the Terminal Value is typically lower than you might expect, since it only begins to kick in 5 or 10 years from now, depending on how many years of cash flow estimates we are using.