Valuation multiples

Receivables, payables and (hidden) financial leverage

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When analysing receivables and payables the focus of investors tends to be on their cash flow and liquidity effects. However, these balances also impact financial leverage and equity risk, which may affect the comparability of valuation metrics. Factoring and other working capital financing contributes to the problem, but all companies are potentially affected.

We explain the leverage effects of receivables and payables, and use two European Auto Parts companies to demonstrate how equity valuation metrics can be adjusted to provide additional analytical insights. We also consider how the accounting for working capital balances and financing arrangements complicates the analysis.

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Net debt in enterprise value – Seasonality and fair values

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Using the most recent balance sheet amount of net debt in enterprise value could produce misleading valuations. Several adjustments may be necessary, including for seasonal fluctuations and where fair value differs from book value.

European travel company TUI is a good example of where the balance sheet net debt may be problematic. We explain when and how to adjust net debt, and why financial statements only partially help. We also consider whether a direct equity valuation, such as using a price earnings ratio, can eliminate net debt complications. 

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Valuation multiples: Return on investment and growth

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Enterprise value multiples, such as EV/NOPAT and EV/EBITDA, can be derived from underlying value drivers, including growth, return on investment, and cost of capital. These calculations benefit from the rigour of an underlying DCF methodology but present the results as familiar valuation multiples.

Our popular target multiple calculator can be used in both absolute valuations and to derive value drivers implied by current market prices. In a new expanded version of the model we add a disaggregation of growth inputs and a more refined measure of return on investment. The interactive model is free to download.

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Relative valuation conflicts – EV/EBITDA versus P/E

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There is usually at least one metric that gives valuation-based support for an investment, even if this is contradicted by other indicators of relative or absolute value. You may have heard comments such as “… but it looks cheap on EV/EBITDA” to help justify a particular investment recommendation.

We examine why different multiples can give conflicting indications of relative value. For example, food-on-the-go stock Greggs trades at a 35% discount to rival Dominos Pizza, based on EV/EBITDA, but at a 24% premium using a price earnings ratio. Which multiple (if either) gives the correct relative valuation?

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Valuing sustainability risks and net-zero commitments

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Investors are paying increased attention to risks and opportunities arising from sustainability related issues, particularly the effects of climate change and related ‘net-zero’ commitments made by many companies. Some sustainability risks directly affect financial statements, but you need to look further when considering inputs for equity valuation.

Risk affects different aspects of equity valuation. It is well known that risk factors affect the discount rate, but the impact on other valuation inputs may get less attention. We explain how sustainability risks and opportunities should be included in your analysis.

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Earnings enhancement, earnings dilution and rights issues

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Although we generally prefer an enterprise value based approach, earnings and price earnings ratios remain an important and legitimate component of equity analysis and valuation. Earnings based analysis includes the earnings per share enhancement or dilutive effects of major transactions.

We discuss the value relevance of earnings enhancement or dilution arising from new capital bring raised and invested, with a focus on rights issues. In an earnings-based approach to analysis, it is important to correctly apply the rights issue adjustment factors to both historical and forecast earnings per share.

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Calculating and analysing the drivers of Equity Beta

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Equity beta is a valid measure of investment risk and an important metric in equity analysis. However, don’t just plug into your models the equity beta given by a data provider – beta should be analysed and adjusted by investors with the same diligence that is applied to performance metrics.

We present an interactive equity beta analysis model to assist investors in better understanding the drivers of equity beta and its application in equity valuation. The model features the calculation of beta (and its volatility and correlation components) for any investment for which price data is available in Microsoft Excel.

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Intrinsic value and the equity risk premium

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Discounted cash flow and similar valuation methods are often cited as the only way to derive an intrinsic value of an equity investment that does not depend on how other assets are priced by the market. In contrast, valuation multiples, such as a price earnings ratio or EV/EBITDA, merely identify value relative to other assets. 

However, this view is not only simplistic – both DCF and valuation multiples can be used in a so-called absolute and relative sense – but it can also be incorrect. We argue that everything is relative in valuation. All equity values, including those presented in financial statements, are measured relative to either current or historical market prices

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Do not use non-GAAP metrics in equity valuation

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A forecast of profit is used for both valuation multiples and as a starting point in deriving free cash flow for DCF valuations. But should you use a forecast of the reported IFRS or GAAP measure, or a forecast of the adjusted non-IFRS or non-GAAP alternative performance measure (APM) presented by management? 

We think equity valuations should be based on forecasts of reported IFRS or GAAP earnings (albeit with some adjustment related to intangible assets). Forecasts of management APMs can be useful for understanding trends in performance but using these in equity valuation is likely to introduce a structural bias.

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Equity analysis using price-multiple charts

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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.

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EBITDA-AL: More letters but no more insight

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In the alphabet soup of investment metrics, a new variant on EBITDA has appeared in some IFRS based company presentations – EBITDA-AL, with the ‘AL’ meaning ‘after leases’. But does the new measure make any sense? And why use EBITDA-AL rather than the established EBITDA or EBITDAR?

All ‘earnings-before’ measures create comparability issues, omit key components of operating performance, and should be interpreted with caution. We think EBITDA-AL is worse than EBITDA, which never was that useful in the first place. Better to use EBIT, EBITA or EBITDA-AMCE, where maintenance capital expenditure replaces D&A.

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Non-controlling interest and NCI put options

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Although accounting for non-controlling interest (NCI) is generally relatively straightforward, including it in equity valuation is more challenging. The reverse is true for NCI that is subject to a put option. In this case the accounting is complex, with different and potentially inconsistent classification and measurement, but useful additional data is available for valuation.

We discuss the accounting and valuation implications of non-controlling interests and use the put option written by LVMH over the non-controlling interest in its subsidiary Moët Hennessy to illustrate the challenges and opportunities for investors.

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DCF terminal values: Using the right exit multiple

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If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date. This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies.

We explain and illustrate with an interactive model the use of forward-priced multiples in DCF. We also discuss the choice of multiple (including why EV/EBITDA may not be the best) and whether to apply the exit multiple to reported or adjusted profit.

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Price to book versus ROE analysis: A case of random numbers?

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The comparison of return on equity with price to book (or the enterprise value equivalents) is a common form of analysis. Some investors claim that the often high correlation between these measures indicates the importance of return on capital. However, all is not what it seems.

This analysis is, in reality, a comparison of price earnings ratios. Adding capital employed may provide additional insight but remember that aggregate returns are most value relevant if they are a predictor of forward-looking incremental returns.

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Real-estate and equity valuation – Opco-Propco analysis

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Companies that use property assets in their business may adopt very different real-estate strategies. Ownership versus leasing and the choice of different lease structures can significantly impact key performance and valuation metrics. We show that separating the operating and property components, using ‘Opco-Propoc’ analysis, improves comparability.

Some investors argue that the new IFRS 16 lease accounting reduces comparability. We disagree. In our view IFRS 16 reveals important differences that prior accounting concealed. However, IFRS 16 does increase the relevance of the Opco-Propco analysis that we advocate.

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Intangible asset accounting and the ‘value’ false negative

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Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book.

The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based investing where price to book ratios are used to identify ‘value’ stocks and related indices.

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Why you should ‘forward price’ valuation multiples

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The number of alternative valuation multiples can seem endless. Many different metrics, such as EBITDA and EPS, can be combined with different measures of value, such as the stock price and enterprise value. But there is a further variation that often seems to be overlooked – the pricing basis.

Valuation multiples can be based on a historical price (or EV), a current price, or the less commonly used forward price. We advocate greater use of forward priced multiples. They are more comparable and relevant for relative valuation comparisons and provide a better basis for terminal values in DCF analysis.

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Enterprise value: Our preference for valuation multiples

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Enterprise value multiples allow for better comparisons where capital structure differs and they provide a clearer focus on the core business. EV multiples also more reliably capture the cost of debt finance and other non-common stock claims; the amount reflected in net income and earnings per share can be out of date and incomplete.

Although they are generally our preferred approach, EV multiples present computational challenges that are not present in equity multiples. All valuation multiples have limitations and are less rigorous than full discounted cash flow analysis.

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Linking value drivers and enterprise value multiples

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Target valuation multiples that are implied by key value drivers are a great way to better understand equity valuation and how the characteristics of a company affect value. The approach incorporates the same links with underlying value drivers on which DCF is based, but in a simplified way that is more intuitive than a full DCF model.

Our target multiple model can be used to estimate a deserved valuation multiple for a company, sector or index, to reverse engineer returns or growth implied by a current market valuation multiple and to derive a terminal value multiple in DCF analysis.

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Interactive model: Target enterprise value multiples

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Use this model to derive ‘target’ enterprise value multiples that are consistent with specified value drivers, including measures of growth, return on investment, margins and capital intensity. The model is based on an underlying 2-stage DCF methodology. We explain its derivation, the key assumptions and how to select appropriate value driver inputs.

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Should you ignore intangible amortisation? – AstraZeneca

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Like many companies, AstraZeneca excludes intangible asset amortisation from its adjusted performance metrics. The stock currently trades at a price earnings ratio of 23x based on ‘core’ 2018 earnings, but without the add back the PE would be about 37x. Is the add back justified? And if so do companies add back the right amount?

The intangible amortisation problem in equity analysis arises from the inconsistency between the accounting for purchased and self-developed intangible assets. We argue that the accounting treatment of subsequent expenditure, either capitalised or expensed, determines the appropriate adjustment to reported earnings.

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EV to EBITDA multiples must be consistent

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Swiss pharma company Novartis provides investors with its own calculation of an EV/EBITDA multiple. However, in our view, the EV is inconsistent with EBITDA. We review the company’s calculation and suggest amendments to ensure it better captures the value of Novartis’ core business.

To derive useful valuation multiples, you must be consistent. Our main adjustment to the Novartis calculation relates to the value of their stake in fellow Swiss pharma company Roche.

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Price earnings ratios – DCF in disguise

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Are you trying to identify what is ‘priced in’ to a current stock price or work out a terminal value in a DCF analysis? A target valuation multiple calculation may be the answer. We present a simple interactive model.

Many dismiss valuation multiples as being too simplistic; however, multiples are just DCF in disguise. You can derive a price earnings ratio with the same value drivers as you would use in a discounted equity cash flow model.

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Enterprise value – calculation and mis-calculation

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Valuation methods based on enterprise value have become the benchmark in equity valuation. Most of you will have analysed equity investments using valuation multiples based on a market enterprise value or have applied absolute valuation methods to derive a target enterprise value.

In simplistic terms enterprise value is market capitalisation plus net debt; but is that good enough? In many situations we think not.  We review the key building blocks of enterprise value to assist you in deriving relevant valuation metrics.

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