Valuation Multiples Explained

| About: SPDR Dow (DIA)
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What exactly is a valuation multiple and why is it important to understand? When you purchase a home, you typically calculate the price per square foot that you are paying for the house (by the way, price per square foot is a multiple). Well for purchasing a stock, an investor needs to understand the valuation multiple they are paying for a stock. Without understanding the multiples and what they mean, you are only betting on the qualitative aspect or the story of the stock, without understanding the basic quantitative aspects or valuation metrics. You are essentially gambling and no longer investing. This article attempts to simply what valuation multiples mean and how you can apply them when considering a stock investment.

Multiples are Like the Inverse of a Dividend Yield

Most people have heard about price to earnings (P/E), however there are also price-to-earnings-to-growth (P/E/G), price-to-book (P/B), and total enterprise value-to-EBITDA (TEV/EBITDA), just to name a few. What exactly does a multiple represent though? Well, the best way to think about it is that just like you look at interest rates to compare different bonds, you need to look at multiples to compare different stocks (you can also look at dividend yield for stocks, but a lot of stocks do not pay dividends so not as comparable). In fact, multiples are like the inverse of a dividend yield. For dividend yield for bonds, you take income divided by the price of the bond. For multiples for stocks, you take the price divided by the income of the stock.

Multiples are Like Price per SF When Buying a Home

Let's also think of multiples in terms of buying a home. When you're looking for a house, you will first look at the list price of the home, let's say it is worth $250,000. You will next look at the total square feet of the home, let's say its 1,000 SF. You will then compare the list price relative to the total square feet to see what you are paying on a "price per square foot" basis. In this case, you're paying $250 per SF ($250,000 divided by 1,000 SF). That $250 price per square foot is a type of multiple, price as a multiple of square foot.

By calculating the price per square foot multiple, you now can look at relative prices across comparable homes. Say you find another house in the same community with similar amenities that is selling at $300,000, but it has a total of 1,500 SF. At first, this 2nd house may seem more expensive, given it's listed at $300,000 versus $250,000. However, if you look at the price per square foot multiple, the 2nd house is actually cheaper by 20%, given that its multiple is only $200/SF ($300,000 divided by 1,500 SF) versus $250/SF for the 1st house.

You would never buy a home without understanding how much price per square foot for the home, as well as how much price per square foot for comparable homes in the same neighborhood. The same applies for buying a stock, you need to understand how much price per earnings you are paying for the stock, as well as price per earnings for comparable stocks in the same industry.

Equity Value versus Enterprise Value

When you look at a multiple, you need to make sure you are comparing apples-to-apples. Meaning when you're looking at Net Income (which are earnings only for equity holders), you need to compare that to Equity Value or Market Capitalization by looking at a P/E multiple. When you're looking at EBITDA (which are earnings for all stake holders including equity, debt, preferred), then you need to compare that with Total Enterprise Value, or "TEV", by looking at a TEV / EBITDA multiple. Before we define and explain the various multiples, we need to first highlight the difference between Equity Value and Enterprise Value.

Equity Value represents the market value of equity in the firm. It is straight forward to calculate, just take the current share price multiplied by the shares outstanding (fully diluted). Equity Value does NOT include debt, preferred, minority interest. It is the equivalent to the home equity of a house, which does not represent the entire home's value and does not include the mortgage debt.

Enterprise Value (or "Total Enterprise Value" or "TEV" or "Firm Value") represents the entire value of the firm, including not only equity value but also debt value, preferred value and minority interest value. This is the equivalent of the entire home value of a home, including both mortgage debt and equity built up in the house.

As mentioned above, Equity Value is like your Home Equity and Enterprise Value is like your Entire Home Value (including Mortgage Debt). In addition, Equity Value is like the Stockholder's Equity on your Balance Sheet, and Enterprise Value is like Total Assets on your Balance Sheet. As covered in the Accounting Tutorial, Assets = Liabilities + Stockholder's Equity. This is the same as Enterprise Value = Net Debt/Preferred/Minority Interest + Equity Value. The only difference is that Assets and Stockholder's Equity represent the Book Value (or Accounting Value shown on their financial statements), while Enterprise Value and Equity Value represent the Market Value (calculated based on the current share price listed in the market).

The following terms or multiples are associated with either Equity Holders (Equity Value) or All Stake Holders (Enterprise Value):

Equity Value Multiples

a) P/E Multiple (P/E = current stock price divided by the earnings per share): P/E ratio helps to indicate whether a stock is overvalued or undervalued, relative to its peers. Consider the following example, Company A has a stock price of $10.00, while Company B has a stock price of $20.00. If you just looked at the stock price, then Company A appears "cheaper". However, because Company B's P/E ratio is 8.0x ($20.00 divided by $2.50) compared to Company A's P/E ratio of 10.0x ($10.00 divided by $1.00), Company B is cheaper, at least on a P/E multiple basis.

But what does 10.0x P/E mean? It means that you are paying a price of 10 times the company's annual net income of $1.00, which means in 10 years, you will have earned back your money. This assumes EPS is constant and does not increase/decrease for the next 10 year. We'll talk about P/E/G multiple next which accounts for growth in EPS.

Invert the P/E: Another way to think about P/E is to invert the 10.0x multiple, or take $1.00 EPS divided by the $10.00 per share you paid for it. This now shows that you earn 10% return on your investment every year, compared to probably 2% you earn if you put it in a CD. The extra 8% premium is to compensate you for investing in a risky asset class (stocks versus a guaranteed CD).

Equity Value / Net Income Multiple: There is no difference between P/E and Equity Value / Net Income. It is the same multiple, except the latter takes into account total shares outstanding. It is still helpful to know what a stock's equity value or market capitalization is (i.e: a company with $200mm market cap probably has much more room to grow than a company with $200bn market cap), but you do not need to calculate market capitalization to get to a P/E multiple.

The lower the P/E, the better. P/E multiple of less than 10x generally indicates the stock is cheap or undervalued.

b) P/E/G Multiple (P/E multiple divided by growth rate divided by 100): Because different companies have different growth rates, therefore another helpful multiple to look at is P/E compared to expected EPS growth rate for the next 5 years. The actual calculation of P/E/G is P/E multiple divided by the growth rate, then divided by 100 (which helps to convert the growth rate, which is a percentage, to a metric that can be compared against P/E).

If we look at our previous example, we see that Company A has projected 5 year EPS growth of 10%, compared to only 6% for Company B. When we calculate the P/E/G ratios, we see that Company A's PEG is 1.00x (10.0x divided by 10% divided by 100) compared to Company B's PEG of 1.33x (8.0x divided by 6% divided by 100). Therefore, although Company B initially looked cheapest when we looked only at P/E ratio (8x compared to 10x), we now see that Company A is actually the cheapest when we factor in the projected growth of the two companies, or when we look at the P/E/G ratios (1.00x compared to 1.33x).

Different companies will grow at different growth rates given where they are in their business cycle or what industry they are in (tech companies like Facebook (NASDAQ:FB) or Amazon (NASDAQ:AMZN) will have high growth rates of +20-30%, compared to mature utilities companies like Duke Energy (NYSE:DUK) with growth rates of 1-5%), or if they have a new product line coming out (say if Apple (NASDAQ:AAPL) introduces new iWatch or iTV).

Also affecting growth is how much dividend the company pays the shareholders versus how much earnings is plowed back into the company for growth (Google (NASDAQ:GOOG) pays no dividend even though they have cash because they're focused on growth, compared to Altria (NYSE:MO) which pays 6% dividend which is 85% of net income, meaning only 15% of net income is retained and plowed back into business for growth).

The lower the P/E/G, the better. P/E/G multiple of less than 1.0x generally indicates the stock is cheap or undervalued.

c) Price / Free Cash Flow Multiple: EPS is an accounting definition of earnings and does not necessarily reflect how much cash earnings the company made in one year. As a result, some value investors prefer to look at a cash flow multiple, either Price / Free Cash Flow or TEV / EBITDA multiple. Note the difference between EBITDA and FCF. EBITDA = Earnings before Interest, Taxes and Depreciation and Amortization. EBITDA is for all stakeholders given that it is before Interest and therefore you need to use TEV. FCF = Net Income + Depreciation and Amortization - Capital Expenditures - Working Capital Needs. FCF is for equity holders only (because it starts with Net Income which is after interest expense) and therefore you need to use Equity Value.

Price /FCF is basically a more pure or honest P/E multiple, given that FCF represents true cash earnings or cash flow and not just an accounting earnings number. However, unlike EPS which has to be reported by public companies in their SEC filings, FCF per share has to be interpreted by an outside analyst. Therefore, it is a more difficult metric to calculate, given the interpretation required.

Lastly, I'd like to make one more subtle point regarding levered FCF versus unlevered FCF. The FCF above is levered FCF, because it is defined as Net Income + Depreciation and Amortization - Capital Expenditures + Working Capital. The FCF used in a Discounted Cash Flow Analysis ("DCF") is unlevered FCF, which basically means it adds back Interest Expense (and therefore for DCF, you use a weighted average cost of capital or WACC to discount, which is the average cost for both equity and debt holders). Levered FCF is cash flow just for equity holders. Unlevered FCF is for both equity and debt holders.

d) Price / Book Value Multiple: Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) likes to reference Berkshire's current book value in his annual shareholder letters as a minimum value of what his company is worth. P/B is the equity value (share price x shares outstanding) divided by the shareholder's equity book value (found on the company's balance sheet). Usually companies are valued at a higher market capitalization than their accounting book value, because accounting rules tend to be very conservative. Therefore, you will usually see P/B of 2.0x or more. P/B around 1.0x is usually considered cheap (it means the market is valuing the company at its equity book value).

Enterprise Value Multiples

TEV/Revenue multiples are best associated with the heydays of the Internet boom, where Internet companies were going public without profit (therefore you could only value them on a revenue multiple basis), or sometimes even without sales (then, you would have to get creative and value them on a TEV / customer or eyeball multiple basis). TEV-to-Sales is sometimes called referred to as "Price to Sales", which is technically incorrect. Remember, "Price" refers to Equity Value, but for Sales and EBITDA multiples, you need to compare it to Enterprise Value. You cannot compare Price (or Equity Value) to Sales.

Company A's TEV / Revenue multiple is 1.0x ($100 TEV divided by $100 Revenue). A few things to note. If a company has no debt, preferred or cash, then Equity Value = Enterprise Value. Note also the relationship between Revenue and Net Income, as they compare to their respective multiples of TEV/Revenue and P/E. In this example, since net income is 10% of revenue, then the P/E multiple is 10x compared to TEV/Revenue multiple of 1.0x.

TEV / EBITDA Multiple:

TEV / EBITDA is the other free cash flow multiple we can look out, besides P/FCF. TEV/EBITDA looks at the Total Enterprise Value divided by EBITDA. EBITDA is the total cash flow available to all stakeholders before it is divided up between debt holders, preferred holders, the government (therefore before taxes), and finally equity holders.

EBITDA is defined as Earnings Before Interest, Taxes, Depreciation and Amortization. It is an approximation for total cash flows available to the firm. The main non-cash expense that is added back is Depreciation and Amortization or D&A. The best way to explain D&A is to think about when you buy a car. Every year, the car value or its blue book value depreciates, because of wear and tear of the automobile from use. Same thing happens with Fixed Assets or Equipment with a company; the equipment depreciates in value every year. If the equipment cost $100,000 to purchase and it is suppose to last for 10 years, then it will have annual depreciation expense of $10,000 ($100,000 divided by 10). Amortization is the same concept but for Intangible Assets (like patent rights, goodwill or brand of the company, etc).


Hopefully this article helped to simply the concept of valuation multiples. Related to this article, I plan on publishing on a weekly basis, the valuation multiples (or comp sheet) for the 30 companies in the Dow Jones Index (NYSEARCA:DIA), to help readers get easy access to multiples for some of the major companies in the markets today. Calculating these multiples do take a bit of time, so given the limited time that I can commit to Seeking Alpha, the 30 companies in the Dow Jones is about all I can handle on a regular basis for now. The 30 companies span various industries including technology, financials, industrials, consumer goods, media & telecom, healthcare, and energy, so it should offer a good overview of current multiples for various sectors.

Disclosure: I am long AAPL, DUK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.