The other commonly used valuation technique is based on using measures of revenues, earnings, or cash flow and capitalizing these amounts using a multiplier that is typical for similar companies. These methods are essen- tially shortcuts or rules of thumb based on economic theory. Users of these methods tend to establish ranges for certain industries. For example, retail companies may trade at a multiple of 0.5 to 1.0 times revenues, while tech- nology companies may trade at 2 to 3 times revenues, or higher. The signif- icant difference between the multiple for the two industries is explained by many factors that are independent of the current revenue level. For exam- ple, expected growth in revenues, profitability, risk, and capital require- ments will impact the revenue multiple. Those familiar with the business characteristics of specific industries, such as market growth, profitability, risk, and capital requirements, can use the method effectively.
In applying multiples, it is important to use consistent measures of in- come and valuation. Specifically, we must determine whether we are at- tempting to estimate the value of the firm (enterprise value) or the value of the equity.
To illustrate these techniques, we will use the information provided in Table 2.5 for Simple Co.
Price/Sales Ratio
This ratio computes the value of the firm to the estimated or recent sales levels. For example, Simple Co. has sales of $100 million and an estimated (enterprise) value of $180 million.
P/S Enterprise Value Sales
million
$100 million
= =$ = ×
180 .
1 8
Other companies in this industry have price-to-sales ratios of 1.3 to 2.0. This would indicate a comparable valuation range of $130 million to
$200 million for Simple Co. The value-to-sales ratio for Simple Co. is within the range of similar or comparable companies.
Advantages: The price-to-sales ratio is a simple, high-level measure.
Disadvantages and limitations: The measure requires many implicit as- sumptions about key elements of financial performance including growth rates, margins, capital requirements, and capital structure.
Price-Earnings (P/E) Ratio
This ratio compares the price of the stock to the firm’s earnings. Using per share information, the P/E ratio is calculated as follows:
For Simple Co.:
The valuation of companies comparable to Simple Co. indicates a P/E ratio range of 16 to 20 times earnings. Simple Co.’s stock price of $10.59 is within the range indicated by the market research ($8.94 to $11.18) using the comparable P/E range.
This measure can also be computed at the firm level:
Advantages: This method is simple to employ and commonly used in practice.
Disadvantages and limitations: Several problems exist with this tech- nique. First, earnings are accounting measures and not directly related to economic performance or cash flows. This has become an increasing prob- lem in recent years as accounting profit continues to diverge from the un- derlying economic performance. Second, this measure also requires many implicit assumptions about key elements of financial performance, includ- ing growth rates, capital requirements, and capital structure.
P/E Market Value of Equity Net Income
million
$9.5 million
= =$ . = ×
180 0 .
18 95
P/E=$ . = ×
$ .10 59 . 0 56 18 95 P/ E Stock Price
Earnings per Share
=
50 CREATING CONTEXT AND COVERING THE BASICS
Enterprise Value/EBIT
This method compares the total value of the firm to the earnings before in- terest and taxes. Recall that EBIT generally approximates operating in- come. Since it is a measure of income before deducting interest expense, it represents income available to all investors, both equity (shareholders) and debt (bondholders). Therefore, we will compare this measure to the total value of the firm (EV).
For Simple Co.:
Advantages: This method is also simple to use. It results in valuations based on earnings available to all investors.
Disadvantages and limitations: This method does not directly take into account other key elements of performance, such as growth or capital requirements.
Enterprise Value/EBITDA
This measure is very close to EV/EBIT, but uses EBITDA as a better ap- proximation of cash flow, since it adds back the noncash charges, deprecia- tion and amortization (D&A).
For Simple Co.:
Other similar companies are valued at 8 to 10 times EBITDA. Based on comparables, Simple Co. is valued just outside the high end of this range of comparables.
Advantages: This method is simple to apply and is based on an ap- proximation of cash flow.
Disadvantages and limitations: The primary limitation with this method is that it does not explicitly account for growth or future capital requirements.
EV EBITDA
million
million million
= $ + =
$ . 190 $ . .
15 0 3 75 10 13
EV EBIT
million million million
=$ +$ =
$ .
180 10
15 12 67
EV EBIT
Market Value of Equity Market Value of Debt
= EBIT+
Price-Earnings/Growth (PEG)
The price-earnings/growth (PEG) ratio is a derivative of the price-earnings ratio that attempts to factor in the impact of growth in price-earnings mul- tiples. The logic here is that there is a strong correlation between growth rates and P/E multiples. Companies with higher projected growth rates of earnings, for example technology companies, should have higher P/E ratios than firms with lower expected growth rates.
The price-earnings/growth ratio is computed as follows:
For Simple Co:
Simple Co. has a very high PEG ratio relative to the peer group. This may reflect a number of factors: perhaps strong cash flows or consistent operating performance relative to the benchmark group.
Advantages: This method reflects a key driver of valuation: expected growth.
Disadvantages and limitations: This measure does not directly reflect other key elements of financial performance.