Wednesday, January 30, 2013

Estimating Value: Part 3 Advantages and Disadvantages of Multiples in Valuation

Two previous posts have talked about the use of discounted cash flow in valuation and the use of multiples in valuation.  At the end of the multiples post I promised to return to the advantages and disadvantages of multiples.  That is the subject of today's post.

Advantages and Disadvantages of Multiples in Valuation
 The main advantages of multiples are that they are relatively easy to use, are based on actual market transactions and can provide a useful ballpark for estimating value. It takes a known quantity for a firm like earnings or book value and converts it into a proposed price for the firm.  The problems associated with multiples are many, starting with the difficulty in finding comparable and timely comparisons.  The multiple approach also presumes that the prices paid for competing firms or their shares of stock were realistic in the first place!  Moreover, the average multiple for a set of transactions disguises the wide range of differences that can exist within a given industry. It is not unusual, for example, to observe an average multiple of 15 times earnings for an industry with a range from 10-20 times earnings representing actual transactions.  Selling your firm for the average of 15 times earnings when you could have received 20 times earning is obviously not maximizing shareholder value. 

To illustrate the wide range of multiples within various industries, consider the Table below taken from some work I developed using Value Line Investment Survey.  The table shows the mean, median and range of price earnings ratios for ten industries during the summer of 2001.  Of particular interest is the extreme range of the multiples within a given industry.  Note the ratio of the range shown in the far right column.  There are only two industries where the range in values from low to high is less than 50% of the median value; both of these industries involve just a handful of firms.  

Table 1: Range of price earnings ratios across industries
Name of Industry# of Cos.MeanLowMedianHigh  Ratio of range     (high – low) to median value
Auto Parts Industry17178.414.730.2149%
Bank Industry3017.913.216.732.2114%
Beverage (soft drinks)824.321.823.827.424%
Hotel/Gaming Industry1617.311.417.131.1116%
Medical Services2818.86.31929.6123%
Newspaper Industry1331.119.130.348.698%
Petroleum (Producing)9127.710.624.2156%
Retail Store Industry2020.97.521.143.3170%
Tobacco Industry611.38.811.313.441%
Source: Value Line Investment Survey – Issues from 7/6/01 through 9/28/01.

Consider the Auto Parts Industry.  The range is from a low of 8.4 to a high of 30.2.  Can you confidently price your company at any of these valuations (or the mean or the median) without more fine tuning?  I think not.  

Moreover, multiples are based on rules of thumb, often learned through the experience of practicioners.  But consider just a few of the factors affecting valuations: economic conditions, consumer tastes, the existence of war, technology, alternate products, complementary products, inflation, etc.  etc. The list could continue for quite some time.  As any of these factors change, so could the multiples.  Even the relative ordering of multiples within industries will change over time (inflation or the price of oil affects industries differently).  This set of multiples measured today would vary considerably.

Also remember the types of multiples shown in the use of multiples  [from Snowden (Table 1)].  In many cases, a range of multiples is provided and often, the range of multiples seems so large as to provide little help in estimating a firm’s value.  

Indeed, analysis of the multiples existing within any particular industry is likely to produce a very large range.  The analyst needs to make subjective adjustments recognizing differences between the firm of interest and the comparison set.  This involves recognizing the current and future earnings power of the companies, reflecting current market conditions, and identifying other important differences between the firm and the comparison set.  At the extreme, recognition of these differences leads to an analysis reminiscent of the detail inherent in a discounted cash flow approach.  

This is not to say that multiples are without merit.  On the contrary.  Multiples are just one other means of valuation with their own advantages and disadvantages.  They also serve as boundary checks on methods like discounted cash flow valuation.  Finally, many analysts that use discounted cash flow to value the next several years of earnings will still use multiples to estimate terminal values.

In the next valuation post, we'll conclude with a look at a related method of valuation: comparables.

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