Advanced Corporate Finance GMIF Additional Material

Multiples Great for Summarizing Valuations, Very dangerous for Performing Valuations

 Philosophy of a multiple  Triangulation  From here on down, everything is the same  Sources of multiples  Comparable companies – “Trading” multiples  Comparable transactions – “Transaction” multiples  Structure of any multiple – ratio between  An easily observable variable (Earnings, Sales, Employees, etc.)  A measure of value (Price, Market Value, etc.)  Both measures should be compatible  Equity Value numerator and FV denominator are incompatible  The inverse of every multiple is a return measure (e.g. P/E and ROE) Basics of multiples

Multiples as Summaries

Summaries of Growth Patterns

Ratio pyramid – FIRM VALUE

RATIO PYRAMID – EQUITY VALUE

First, Agree on a Discount Rate

 Three underlying concepts behind every multiple  Growth rate  Discount rate  Relationship between driver variable and UFCF How to analyze a multiple  Differences in ratios may come from structural differences in business structure (margins, turnovers, etc.) rather than from growth and risk

 Choice between  Using too many data points and including some that are not really comparable  Using too few data points and cherry-picking comparables to get the desired result  Best practice 1. First analyze value range based on broadest possible set of comparables 2. Pick all companies that compete against target 3. See if there are clearly identifiable subgroups amongst comparables 4. Check if these subgroups stay constant when using different multiples Choosing comparable companies

 Identify possible conditioning variables  Market returns  Market expectations (especially of growth)  Industry ratios (P/B especially)  Take into account inflation  Take into account Private Benefits of Control  Take into account synergies  Take into account post-transaction industry structure (market power)  Take into account eventual result of transactions to separate optimistic from objective valuations Choosing comparable transactions

Key Multiples

 Most widely used multiple  Inverse is ROE at market values, immediate measure of Equity holders potential returns  Since  “Normal” P /E is  1/r with no growth  1 / (r – g) for forward-looking multiples  Unless ROE is above r E additional growth is irrelevant for valuation  Maximum sustainable growth rate:  Where k is the payout ratio Key multiples: P/E

 “Normal” value is 1  Values above 1 represent the present value of abnormal (extraordinary) returns  Values under 1 signal distressed company, as accounting follows principle of prudence  Differing accounting standards might lead to different P/Bs, even in the long run  Sometimes used as a proxy for Tobin’s q (Market value / Replacement value) Key multiples: P/B

 Aka misleadingly as EV / EBITDA  Firm Value (IC) equivalent to P/E  EBITDA is easily computable, but not a very good proxy for UFCF (the theoretically sound variable to use)  As a Firm Value multiple it only looks at Operating Performance and Asset Value  Typically used in industries with low asset turnovers and subject to egregious earnings manipulations through the capitalization of R&D or other expenditures  Discount rate to be used is WACC Key multiples: FV / EBITDA

 In Vogue during the dotcom bubble  Used extensively in early-stage VC  How do you value a company with no profits, not even sales  Make “heroic” assumptions about inter-firm comparability  Susceptible to easy manipulation by management  Examples:  FV / PhD, FV / suscriber, FV / click Key multiples: moneyless multiples

 Equivalent Multiples  Main Returns  ROE  ROA  ROIC (aka ROCE)  ROMVIC  ROI  CFROI Multiples and returns EquityFirm Accounting ProfitabilityP / EFV / NOPAT Market ValuationP / BFV / IC Cash ProfitabilityP / CFPSFV / UFCF

RATIOS and drivers

 Forecast flow rather than stock variables  Income Statement and Cash Flow statement accounts are easier to forecast than Balance Sheet accounts  Greatest exception to this rule is Debt - it makes more sense to target a certain leverage ratio (Debt / IC)  Forecast Balance Sheet items based on movements in  Income Statement  Balance Sheet  Every Balance Sheet movement must be reflected in either or both  Otherwise balance sheet will not balance  Every CFS and IS movement should affect the Balance Sheet  Otherwise balance sheet (or reconciliation of cash) will not balance Forecasting dos and don’ts

 “Normal” is level without growth  If ROE = r then P = B  The “normal” value of P/B is 1  We do not expect abnormal earnings  From the dividend discount model  “Normal” (no growth) P/E is a function of pay-out and ROE “Normal” P/E and P/B

 “Normal” P/E in terms of EBO is  P/E is normal if current abnormal earnings continue at same level in the future EBO And multiple “normality”

Relationship between p/B and P/E

 “Cosmetic” changes to increase earnings result in higher book values and therefore lower future abnormal earnings – effect washes out  Example  Initial Book Value €5,000  Initial Net Income €1,000  Two choices  Expense restructuring charge of €300 all during 2010  Expense charge over the period  Valuation by EBO at year end 2010 is the same  Also true for valuation at beginning 2010 Self-correcting Nature Of Accounting

YearBook t-1 IncomeChargeNet Income Req. Return EaEa 2010€ 5,000€ 1,000€ 300€ ,700 1,050 0 € 570€ ,750 1, ,850 1, EXAMPLE YearBook t-1 IncomeChargeNet Income Req. Return EaEa 2010€ 5,000€ 1,000€ 0€ 1, ,000 1, € 600€ ,900 1, , ,900 1, ,