**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. **

Multiples based on historical prices are commonly used to describe how a stock was valued in the past, to establish trading ranges and to provide a comparison for current valuations. If you see a multiple quoted for a past period, then it is almost certainly historically priced.

Historical multiples are commonly presented as the average stock price or EV for a period divided by the actual profit for that same period. An alternative, and our preferred approach, is to combine historical prices with the consensus forecast at the time, for example, combining a price in 2018 with the consensus forecast of 2019 profit that was available in 2018. Using a forward-looking profit metric is more consistent with the forward-looking nature of prices. This also avoids much of the ‘one-time item’ problem with actual reported earnings and ensures greater comparability of historical multiples to current and forward priced multiples if these are calculated using the same prospective earnings approach.

However, historical priced multiples tell you nothing about how a stock is valued today. For that the reference needs to be the current price or enterprise value, combined with either the most recent actual profit or a forecast of a relevant prospective profit. This could be the last or next fiscal year result or an apportioned (or quarterly results based) last twelve-month (LTM) or next twelve-month (NTM) measure.

The problem with current priced multiples is that they can be difficult to interpret and use, particularly where the current or first-year forecast level of profitability is not representative of expected longer-term performance. This may, for example, be due to current adverse trading conditions followed by an expected recovery, or simply because of high forecast growth or significant decline in profit. Cyclical sectors can be a particular challenge. In each of these cases the current-priced multiple must be interpreted in the light of the short-term profit changes, as well as considering the longer-term prospects of the business.

A possible remedy is to use a forecast profit measure further out into the future, such as the second or third year prospective forecast. However, this creates comparability issues, including those arising from differences in intervening cash flows and, potentially, cost of capital. A second or third year prospective current priced multiple would also not be comparable with historical priced multiples that are more likely to be based on, say, the first-year prospective forecast, thus reducing the benefit of historical comparison.

The solution to these comparability problems is to use forward priced multiples.

**Summary of alternative pricing bases for valuation multiples**

Pricing basis | Method | Application |

Historical | Historical price or EV, either on a specified date or the average price or EV for a specified period. | To provide a historical comparison for current and forward priced multiples and to establish a historical trading range. |

Current | Current stock price or EV. | To measure a stock’s value today and provide a basis for comparison with other companies or with historical values. |

Forward | Current price or EV converted to an equivalent forward value, reflecting a normal cost of capital return and the effect of cash transactions with the providers of finance. | An alternative way of assessing value today that can provide a better basis for relative valuation and for exit or terminal value multiples in DCF analysis. |

**What are forward priced multiples?**

A forward price or enterprise value is the current value increased over a selected period to reflect the required return of investors (the cost of capital) and reduced by the cash flows distributed to those investors. A forward price is an estimate of what the actual value would be in that future period if all drivers of value, such as cash flows and growth, turned out as previously expected and hence investors earned a normal return commensurate with the risk of their investment.

For example, if a current stock price is 100, the cost of capital or investor required return applicable to the level of risk of the stock is 10% and a dividend of 3 is forecast for the next period, then the 12-month forward price would be 107. The capital growth of 7 plus the dividend of 3 gives the investor the fair risk adjusted return of 10% over the period.

The forward price is not the same as a price target because an investor may well have a different view about the prospects for a company. Nor is a forward price what the stock price will actually be in one year’s time because this clearly depends on how events turn out. A forward price is an adjusted current price. As a result, multiples based on a forward price provide information about the current market valuation of a stock or business and therefore can be used to make decisions related to that valuation.

In effect, a forward price is a terminal value in a DCF valuation which, when discounted to a present value at the relevant cost of equity (COE) and added to the present value of dividends expected to be paid during that forecast period, gives a present value equal to the current stock price.

The standard DCF calculation of a stock price is …

{ \sf { Current \,price \,= \,PV \,Dividends \,Year_{1}\, to \,Year_{n} \,+ PV \,Terminal \,value \,at \,year_{n} }}

Rearranging this gives the calculation of a forward price …

{ \sf {Forward \,price \,= \,(Current \,price \,– \,PV \,dividends \,Y_{1} \,to \,Y_{n}) \,* \,(1 + COE)^n }}

A forward enterprise value follows the same calculation except that a weighted average cost of capital replaces the cost of equity, and enterprise free cash flow replaces the dividends to equity investors. Enterprise free cash flow is normally calculated as profit available to all providers of finance less the amount of reinvestment in the business. However, this also equals the aggregate amount available to all providers of finance, either by way of a return on their investment, such as interest or dividends, or to reduce that investment, such as repaying debt.

Forward prices can be calculated for any future date and can be combined with any measure of performance to produce a valuation multiple. However, for comparability purposes it makes most sense to be consistent with how historical and current priced multiples are calculated. If current priced multiples reflect the forward 12-month forecast earnings than do the same for forward priced multiples. For example, combine a 2-year forward price with the apportioned forecast earnings from year 2 to year 3.

**A
simplified calculation**

An alternative and simpler approach to calculate a forward price or enterprise value is to use a dividend yield or free cash flow yield in place of an explicit forecast of dividends and free cash flow. This is only perfectly accurate where the rate of dividend or free cash flow growth is equal to the cost of capital less the dividend or cash flow yield. However, if an average yield over the forecast period is used then the result is generally close enough.

Using this method, the calculation becomes:

{ \sf {Forward \,price \,at \,t_{n} \,= \,Price \,at \,t_{0} \,*\,(1 + COE \,– \,Forecast \,dividend \,yield)^n }}

Just substitute WACC for COE and enterprise free cash flow yield for dividend yield to obtain a forward enterprise value.

The simplified approach to calculating a forward price above can be used to directly calculate a forward multiple from a current priced multiple. Applying a profit growth rate to the denominator and the cost of capital less cash flow yield adjustment to the numerator produces a forward price relative to a forward profit metric. Applying this to a price earnings ratio gives:

{ \sf {PER \,forward \,n \,years \,= \,PER \,current \,* \,\, \dfrac {(1 + COE \,– \,Forecast \,dividend \,yield)^n} {(1 + Growth)^n} }}

**The logic of forward priced multiples**

A combination of profit growth, cash flow yield and cost of capital determines the relationship between a current priced multiple of current profit and a forward priced multiple of forward profit. Here is how it works and why:

Driver | Impact | Why |

Profit growth | Higher forecast growth results in a lower forward priced multiple. | The forward multiple is ex short-term growth. High growth results in high multiples so once some of that growth has materialised then the (forward) multiple is lower. |

Cash flow yield | High cash flow yield (dividend or equity free cash flow) results in a lower forward priced multiple. | More cash flow, and hence value, has been generated in the near term which means that the forward price or EV does not need to be as high to justify the current price. This results in a lower forward multiple. |

Cost of capital | Higher cost of capital results in a higher forward priced multiple. | For a given profit growth and cash conversion the forward price needs to be higher to satisfy a higher required investor return. |

There are different ways to think about forward priced multiples and how they change over time …

**Changes in value drivers:**In DCF, overall value is commonly split between the explicit forecast period and the terminal value. Each stage in DCF has its own value drivers, particularly growth and cash conversion. The difference between value drivers for the explicit forecast period and for the terminal value also determines the difference between a current and forward multiple. If stage 1 profit growth and cash conversion is better than stage 2, the forward multiple is lower. The forward multiple is, in effect, the multiple derived purely from the stage 2 value drivers.

**Required return versus growth:**Consider what happens to the numerator (share price and enterprise value) and denominator (such as Earnings Per Share or EBITDA) between now and the year for the forward multiple. If the growth in the numerator exceeds the growth in the denominator, the forward multiple will be higher than the current multiple. In other words, if the cost of capital less cash flow yield is less (more) than the growth in profit then the forward multiple will be lower (higher) than the current multiple.

The calculations of forward priced multiples are illustrated in our interactive model. The first example below is based on the explicit forecast of free cash flow and shows how a series of forward multiples can be calculated. The second example illustrates a comparison of two companies based on the simplified free cash flow yield approach.

**Interactive model: Forward priced multiple calculation examples**

— iphone and ipad users: This model formats best if viewed in Google Chrome —

Note: This model illustrates some simple calculations of forward priced multiples. See below for explanation of the figures in one of these examples.

**Applying
forward priced multiples – relative valuation comparisons**

The data in the second example above illustrates how forward priced multiples can be a better basis for relative valuation comparisons. The data shown when the page is first loaded (you can input your own values) shows two companies with different growth, cost of capital and dividend (or free cash flow) yield.

High forecast growth company 1 trades on a higher multiple of current price compared with first year forecast profit (19.4x versus 10.0x). This is to be expected given the higher growth; but, without further analysis it is difficult to determine whether this difference in valuation multiple is justified.

One approach might be to compare current priced multiples based on a forecast profit that is further out and that consequently captures some of the growth differential. This seems to show that company 1 is cheaper (7.0x versus 9.1x). However, these multiples are not comparable with each other, due to differences in cash flow and cost of capital over the 5-year forecast period.

Forward priced multiples based on year 5 profit provides the most relevant comparison. The forward multiple approach enables investors to deal with not only differences in growth but also differences in cash conversion and cost of capital during the next 5 years, within the multiple itself. In our example the forward multiples are almost identical (9.9x versus 10.0x) indicating that the market valuation of these companies is consistent.

Of course, this does not mean that the two companies are both fairly priced. If, say, the growth or cash flow prospects of these companies differ beyond year 5 then the similar relative valuation indicated by the forward priced multiples may not be justified.

A further advantage of forward multiples is that they can be compared with multiples of other companies that might be based on a different forward period. All forward priced multiples are comparable with a current priced or even historically priced multiple for a comparable company, as long as the relationship between price and profit (first-year prospective, forward 12 months, etc) is the same.

Remember that any valuation based on multiples and a single performance metric, such as earnings or EBITDA, is inherently simplistic in comparison with a full DCF model. However, most DCF analysis includes simplifications for a terminal period anyway and therefore a forward priced multiple captures the most relevant portion of a DCF model but presents the valuation as a familiar and simple multiple. We think that forward priced multiples are worth the added effort involved in their calculation and deserve a more prominent place in investment research.

**Applying forward
priced multiples – DCF terminal values**

DCF values are often driven primarily by the terminal value at the end of an explicit forecast period. In part, the terminal value is determined by the explicit forecast itself because it is the final period of this forecast on which the terminal value is based. However, the long-term assumptions regarding continuing value drivers in the terminal period tend to dominate.

Terminal values are often calculated by applying a terminal multiple to a profit or cash flow metric at the end of the explicit forecast period, with the multiple itself derived from that of other companies or from a sector average. There may also be an overlay of a premium or discount to allow for differences between the company being valued and the sector.

But a common mistake, and potential source of bias in a DCF valuation, is to base the terminal multiple on the current priced multiple for other comparable stocks. This works fine if the expected characteristics (forecast growth, etc.) of the company being valued, when assessed at the end of the explicit forecast period, are the same as the sector characteristics at the earlier valuation date. However, this will rarely be the case.

A better approach is to calculate a sector or comparable company forward-priced multiple for the same period as the terminal value calculation.

**Insights for investors**

**Multiples which are quoted for historical periods are generally historically priced. They inform about past valuation and trading ranges and not about current values.**

**Current priced multiples can be difficult to interpret where there are significant differences in short-term value drivers such as profit growth or cash conversion.**

**Forward priced multiples based on metrics further into the future can be more comparable and can give a better indication of differences in relative value.**

**Current priced multiples are only comparable if the relationship between price (or EV) and the profit metric are the same. Don’t compare a current priced multiple based on a first-year forecast profit with another current priced multiple based on the second-year forecast profit. The forward price versions, on the other hand, are comparable.**

**Use sector or comparable company forward priced multiples for DCF terminal values in preference to current priced multiples.**

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