In this final article on Corporate Valuation, I discuss the Valuation Multiple approach. The method is probably one of the most common approaches to valuation because it requires little detailed analysis of a company’s annual accounts and can be carried out relatively quickly.
It is also one of the best approaches when a company is private and there is no share price available.
Interested readers are invited to read Chapters 12 and 13 of my book, Financial Markets and Corporate Strategy, where I explore the method in considerably greater depth.
Which Multiple to Use?
The best multiple for a particular company will depend on its industry and growth opportunities. Multiples that are regularly used are given below:
Enterprise Value = Market value of equity + Debt – Cash and Cash Equivalents
- Identify peers/benchmarks for the company.
- Find the valuation multiples for the comparator firms.
- Calculate the median or mean multiples of the peer group.
- Calculate the expected multiple for your chosen firm and use to value equity.
I will use Carillion plc as a case study to maintain consistency with earlier articles.
Step 1: Identify peers/benchmarks for the company
You will recall from previous articles in this series that Carillion has four different business lines: Support Services, Public Private Partnerships, Middle East Construction Services, and Construction Services (Excluding Middle East).
If I was carrying out a full valuation of Carillion, I would do a peer analysis by business line and calculate a weighted average ratios for the firm. However, to keep the article short and less than 1,000 words, I will only do the valuation analysis at the company level. The full approach is covered in my textbook, Financial Markets and Corporate Strategy.
You can easily find the peers of a company by going to Google Finance and searching for the firm. On the page you will get a list of peers.
For Carillion, I got the following:
I clicked on the ‘Related Companies’ link, then ‘Add or Remove Columns’ and chose the following:
The valuation multiples we will use are the Price Earnings Ratio, Price/Book Ratio, and Price/Sales ratio.
Step 3: Calculate the median or mean multiples of the peers.
Simply calculate the average of all the firms on the list. These are:
Step 4: Calculate the expected multiple for your chosen firm and use to value equity.
With a price of £3.30, it is a simple matter to calculate the denominator for each of Carillion’s ratios. For example, with a P/E ratio of 14.22, the denominator (Earnings) of the P/E ratio is £3.30/14.22 = £0.23. This is also the Earnings per share, which is shown in the Google Finance output above.
On the basis of the comparator figures, one would expect the following prices for Carillion.
Price/Earnings: £0.23 x 22.48 = £5.17
Price/Book: £2.24 x 2.53 = £6.17
Price/Sales: £7.67 x 1.08 = £8.29
All of these valuation estimates are substantially higher than the actual price.
With such a large discrepancy, the choice of comparator firms should come under greater scrutiny.
As a check, I carried out the same analysis using Morningstar data. Morningstar gave the following companies as Carillion’s peers:
Notice that the firms are completely different!
On the basis of these figures, Carillion would have the following valuations:
The total value of Carillion plc equity is the share price x number of shares (430.25 million). The expected Equity market capitalisation using the Morningstar data are thus:
We then add the total liabilities (£2.6563 billion) to arrive at a valuation estimate for each ratio:
These compare to the other values of £4.089 billion, £4.113 billion, and £3.984 billion from the other methods.
Strengths and Weaknesses:
The strengths of the Valuation Multiples method are:
- There is a massive number of different multiples one could look at and so you have different ways to arrive at valuations.
- Ratios are very simple to calculate and they are easy to interpret.
- You are valuing a firm based on other companies in the same sector. Differences between the actual share price and estimated values can provide much insight into where the company could improve its operations.
The weaknesses of the method are:
- It can be difficult to identify appropriate peers for the company. Choose the wrong ones and your value estimates will be wrong.
- It is easy to focus on the wrong multiples given that there are so many to choose from.
- The method does not actually look at the company’s figures but uses other company data to arrive at a value.
In this series of articles I have tried to provide a simple approach to firm valuation. There are many factors I didn’t consider as my objective was to show you the general approach to value firms, rather than to look at the specific valuation of any one firm.
It is important in this regard to remember that these methods must be adapted to the specific sector the firm is operating in. They also need to be modified when firms have negative earnings.