Valuation multiples, such as a price earnings ratio or EV/EBITDA, can be based on either historical, current or forward prices. All three approaches individually provide valuable insights but combining them provides a bigger picture and facilitates further analysis.
A price-multiple chart shows historical, current and forward stock prices or enterprise values with an overlay of valuation multiples. The historical portion of the chart puts stock price changes in the context of historical profit forecasts and revisions. The forward portion provides further insights into current value and analyst target prices.
In previous articles we explained the different pricing bases for valuation multiples, including the less common forward pricing, and how each can be used in equity analysis.
- In ‘Why you should forward-price valuation multiples’ we explain how to calculate forward prices and enterprise values and discuss the benefits of using forward-priced multiples in making relative value comparisons.
- In ‘DCF terminal values: Using the right exit multiple’ we explain how forward-priced multiples can provide a better basis to determine continuing or terminal value at the end of an explicit forecast period in DCF valuations. Applying forward-priced multiples for a peer group of comparable companies makes it more likely that the exit multiple appropriately reflects expected business dynamics at the end of the explicit forecast period.
In both articles we include interactive models to illustrate the calculations.
A forward price or EV is simply the expected future value assuming actual return equals expected return. For the stock price it is current price compounded by the cost of equity (the expected return) less the forecast dividend yield.1For companies where significant share buybacks are forecast the forward price should also allow for the ‘buyback yield’. Either add the buyback yield to the dividend yield or adjust the forward EPS to reflect the expected reduced share count – but don’t do both. A forward enterprise value is the sum of the forward equity value plus the forecast amount for other EV components, such as net debt. Alternatively, a forward EV can be calculated by compounding the current EV at WACC less the forecast free cash flow yield. Both approaches must give the same result. See our article ‘Why you should forward-price valuation multiples’ for worked examples and a downloadable spreadsheet that illustrates the calculation.
Here is a summary of the three pricing bases, their calculation and application.
Summary of alternative pricing bases for valuation multiples
We think that a forward price or enterprise value combined with forecast profit metrics provide a more reliable basis on which to analyse relative value. The approach enables more forward-looking metrics to be used, but at the same time the results are directly comparable with historical multiples. For example, a forward price for 2 years’ time divided by year 3 forecast earnings moves the basis for the valuation to a future period, which is more likely to be representative of sustainable profit in the longer term. Year 1 and 2 performance is not lost in the analysis since this is reflected in the cash flow yield adjustment component of the forward calculation.
Forward priced multiples give better comparability
In addition, forward pricing produces multiples that are comparable over time. For example, the above 2 year forward multiple is comparable with a current-priced multiple based on the first-year forecast profit and also historical multiples based on historical prices and the first-year forecast that was current at that time.
It is this comparability over time that facilitates the application of price-multiple charts.
Price-multiple charts
There is another use of different multiple pricing bases that we think merits greater attention by investors … price-multiple charts. In our experience it is rare to see forward-priced multiples applied in practice and even less common to see them presented in this graphical format. The charts provide visual representation of valuation multiples by overlaying ‘multiple bands’ on a share price chart.
Here is an example:
Price and price earnings ratio chart
The chart shows the historical stock price for a company for the last four years, together with a dotted line indicating the forward prices, taking into account the assumed cost of equity capital and expected dividend payments.
Overlaid onto this are PE ratio bands. These represent stock prices that equal the forward 12-month consensus (or analyst) earnings forecast on each specified date, multiplied by the relevant PE value for that band. These lines show how consensus 12-month forward forecasts have changed over time and, for forecast dates, it shows the progression of earnings forecasts further out into the future. The PE bands are historically-priced where the stock price is historical, current-priced as at the current date and forward-priced for future dates. All these multiples are comparable and combine with the price data to produce a stock price chart that we think is exceptionally useful in telling the ‘valuation story’.
For the company in this example, the stock price has followed a path that is similar to the change in price-earnings ratio bands, although in a more exaggerated way. The fall in the PE band lines in 2018 and 2019 indicates earnings forecasts were downgraded over that period. The stock price also falls, but by an amount that exceeded the reduction in consensus earnings, as evidenced by the PE falling from above 15x to around 10x. This may be the result of the market reassessing growth prospects on the back of the earnings downgrade. The opposite has happened in the subsequent period with a stock re-rating to over 20x, even though the earnings forecasts have risen only modestly.
Forward PE bands reflect consensus earnings growth
You will notice that the multiple bands in the chart have been extended to incorporate forward profit forecasts so that any target stock price for, say, forward 12 months, can be viewed in the context of those multiples. The steeper slope of these forward PE bands reflects stronger consensus earnings growth in the next few years, which is consistent with the stock’s recent re-rating. These forecast multiples are based on the forward-pricing methodology we describe above.
Of course, valuation multiples are simplistic measures of value based on a single period of profit or cash flow. They are no substitute for a more comprehensive discounted cash flow based analysis or, even better, a sum-of-parts calculation that is itself based on underlying DCF calculations. However, multiples are extremely useful in providing a clear measure of value summarised as a single number, which can often facilitate better judgements. Discounted cash flow has so many moving parts and inputs that it is often difficult to identify how aggressive or conservative the valuation is.
But if you use multiples, we think this the best approach:
- Use enterprise value multiples rather than equity multiples to ensure greater comparability where there are differences in capital structure – see our article ‘Enterprise value: Our preference for valuation multiples’.
- Do not use EV/EBITDA due to the omission of key value drivers – see our article EBITDA-AL: More letters but no more insight.
- Base multiples on forecast profit or cash flow measures, preferably year ‘2e’, the first fully forecast period, or beyond.
- Use the forward pricing methodology for year 2e and beyond to ensure comparability over time, enhanced comparability with other companies, and to capture the free cash flow generation in the intervening period.
- Use historical pricing to establish trading ranges and to analyse how past prices have reacted to profit forecast changes.
- Put it all together by using price-multiple charts.
Insights for investors
- Multiples can be historical, current or forward priced. Historical-priced multiples establish trading ranges and facilitate understanding of past price changes. Current and forward-priced multiples are used to compare and analyse current prices.
- Forward-priced multiples based on forecast performance metrics provide greater comparability and relevance. They are also comparable to historical multiples.
- A price-multiple chart can be useful when making valuation comparisons and provide a bigger picture than merely quoting individual multiples.
- Include forward multiples and implied forward prices in price-multiple charts. Historical prices and trading ranges is useful analysis, but only part of the valuation story.
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