What’s Missing in Your Multiple
Multiples are nice and clean, or are they? I know people who throw around multiples as if they are the most reliable pricing tool there is. There is a danger in that type of thinking. Let’s look at what multiples do and don’t tell us and then you be the judge.
First of all, multiples can provide either an entity value or an equity value. The difference between entity value and equity level is the amount of debt. (Entity Value – Debt = Equity Value). The Price / Earnings (“P/E”) multiple is an equity multiple, it provides the price of a common share compared to the earnings per common share. However, EBITDA is an entity multiple, when you hear a phrase like, “Four times EBITDA”, you should know the result is the value of the total enterprise, before any debt. Most of the time, the P/E is calculated using Earnings Per Share (“EPS”) from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E.
Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. A P/E ratio of 15 suggests that investors are willing to pay $15 for every $1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects. That is, for two companies with the same level of earnings per share, the company that is viewed with more potential to grow will normally have a higher P/E ratio. Investors will pay more for a company with growth potential compared to a company with flat growth prospects.
Why Equity Multiples Can Be Misleading
Differences in accounting policies that don’t affect cash flows should not affect value. But, accounting policy differences do affect the reporting of net income. Depreciation expense, amortization of intangible assets, and deferred income taxes, are just a few of the differences that can distort P/E ratios. For two identical companies, the one with the higher P/E ratio will most likely have a higher expectation for future growth. Investors pay for the future cash flows and most likely, the prospect for future growth is embedded in the stock price.
Conclusion
Multiples are informative but not reliable as the sole indicator of value. In addition, if past results are not indicative of future results, other valuation and pricing methods are appropriate. We can guide you in understanding the value drivers of your business. Let us know how we can help.