One of the easiest ways of getting ahead in finance is learning how to use multiples correctly. If you’re going into your summer internship. Or if you’re prepping for the fall interview rounds. Learn how to use valuation multiples now.
Multiples are used to quickly find an estimated value of a company. They are never completely correct, but they shouldn’t be far off either.
A lot of people use them incorrectly. And it can be tricky to know which multiple to use. But with helpful guidance; understanding them should be easy. This is an introduction to valuation multiples.
- Secret interview prep tips: If you want to get a cheat sheet with key info to know about each multiple, click here.
Multiples are all the rage in finance. Often simple to find, and you can compare the price of companies to try to find yourself (or your client) a bargain.
The first thing you should do when looking into valuation multiples is to learn which ones are common within your industry. Then you should look at the average multiples for companies within that industry and learn them by heart.
But what if all the valuation multiples in an industry are crazy, and everything crashes? That’s a possibility. It can happen, so use your logical sense as well. Yes, social media shares, I’m talking to you.
Know why your multiples look odd
If you know what value your multiples should have, you know when they are off. Anytime you see something that differs significantly from the average; you need to spot it.
If a multiple is unusually high or low, you should always triple check. Make sure that it wasn’t a mistake in your inputs that caused the multiple to look crazy.
You need to be able to explain why it differs from the average as well. It doesn’t matter if your multiple calculations are correct unless you can explain why they look as they do. Your boss will always ask you questions if your multiples look weird.
Read further to learn which basic valuation multiples you need to know for an investment banking job interview.
The P/E multiple
P/E is Price dividend by Earnings or Earnings Per Share (EPS). This multiple is all about reflecting the growth in a company’s earnings.
We see this if we go back to a fundamental valuation based on Gordon’s growth formula. This formula models the company as an infinite amount of cash flows going to the investor.
In the formula below, k is the investor’s required rate of return, while g is annual growth of earnings.
We know that a “normal” P/E is around 15. Using an example with earnings of 10, and a required return of 10%, the growth ratio of the company has to be 3.3%. Which isn’t completely unheard of. Thus, we know that multiples make sense from a theoretical valuation point of view as well.
If the earnings grow quicker or slower, this will affect the valuation. If the growth is slow at 1%, the price would be 111, and the P/E ratio would go down to 11.1.
Weaknesses of the P/E ratio
So the P/E ratio looks great. Why doesn’t everyone use that one and be done with it? Unfortunately, the P/E multiple has its weaknesses.
The weakness of the P/E ratio comes from he the fact that we are just using two simple measurements. Earnings to the shareholders and price do not consider the capital structure of the company, its investments or its dividend policy.
Example questions you will be asked to understand P/E
To understand valuation multiples for job interviews, you need to prepare for the questions you will get about them.
The questions are designed to check if you understand how the multiples work. Usually by asking you to track what happens if one or more inputs from the company change.
What happens if a company takes on more debt?
If everything else stays the same, the company now pays interest to the bank and a different amount of taxes.
We started with an example company which has a share price of 150 and EPS of 10. The P/E ratio was then 15.
Let’s say the company increased its debt from 0 to 50%, pay 4% interest, and the tax rate is 33%. The company now has 150 in debt per share. They pay 6 per share in interest costs and pay 2 less in taxes.
The company’s new EPS is 10-6+2 = 6. The new P/E is 150/6 = 25. See now why it doesn’t make sense to compare companies with different capital structures?
What happens if the Board decides to pay out a dividend?
Then their P/E ratio will again be affected. But how?
If they pay a dividend of 10 per share, the price will immediately drop to 140. However, earnings aren’t affected by this in the short term, so the P/E ratio will drop to 14. The company will now look cheaper compared to their peers, but they aren’t.
What happens with a company that has retained significant amounts of cash?
If a company holds a lot of cash, this will also give a weird multiple.
Think about the same company that traded at a P/E of 15. What if they, in addition, held a cash value of 50 per share. You can imagine this as the opposite of the dividend example.
If the cash is just sitting there, it won’t affect the earnings. But the price would increase from 150 to 200. The same company would now start to look more expensive, with a P/E multiple of 20.
Some people then think it’s more accurate to subtract the cash from the Price. This is called a cash-adjusted P/E ratio, or CAPE. However, this breaks with one of the core principles of multiples:
Include the same type of cashflows both above and below the fraction bar.
Cash is a part of the net debt, so including this, means that we should also include cash flow from interests, etc. This is one of the reasons why using a different type of multiple would be more appropriate in this case.
The basics of the EV/EBIT multiple
One of the ways of including a company’s capital structure in a multiple is to look at the EV/EBIT multiple instead. We are now looking at the earnings to the entire capital structure, so changing the amount of debt would not affect the multiple.
What happens when the same company adds debt?
If the company has an EBIT of 12, and the price is 150, the EV/EBIT multiple is 12.5.
If the company then takes on 150 of debt, nothing with the EV will change. This is net debt, so the 150 of cash remove the 150 of debt.
And the EBIT isn’t affected either. Remember that only Interest and Taxes were affected, and they are both excluded from the EBIT.
Dividends would still give you trouble
Paying out dividends would, however, change it. Paying out the same 10 would decrease EV to 140, and EV/EBIT would be 11.2
The EV/EBIT will also give you trouble with different investments and depreciation schedules.
What happens if the same company had just acquired new equipment, and thus increased the depreciation of 6 per share?
The EBIT decreases to 6, and the multiple increases to 25. It could have the same earnings potential as earlier, but it has a different P&L.
Does it make sense to pay less for the company because of this? Not necessarily. For companies with different depreciation schedules, it makes sense to use a different approach.
The EV/EBITDA multiple
We can take another step back and look at the EV/EBITDA multiple. We would now avoid the problem we had before with different depreciation schedules.
However, there are still a few tricky things we need to adjust for to our valuation correct.
If the company holds a lot of cash, this should not be included in the enterprise value. The reason is that you don’t include the interest on the cash in the earnings.
Another thing to adjust for is leases. A lease is effectively a debt that we are paying back; it just has a fancy name.
This debt must be included in the enterprise value, and the cost of paying for this lease must be excluded since this is an interest or amortization payment.
Why doesn’t everyone use EV/EBITDA?
If EBIT and EBITDA multiples solve the problems with capex and financing, it sounds tempting always to use those.
Both the EBIT and EBITDA multiples have some issues because we are now excluding essential things like taxes.
What if the tax rate increases for the company? This would mean less cash to shareholders, yet the multiple wouldn’t indicate any change.
The same happens if the interest rate increases. And a company continuously making bad investments would have the same EBITDA, but the cash they give to shareholders would be less.
Read further to get key investment banking interview questions you will be asked on EV/EBITDA
What happens to the multiple if the tax rate increases from 33% to 50%?
So the EV is 150, the EBITDA 15, and the multiple is 10. Remember that the EPS was 10. This is 10 that goes to shareholders each year.
If the tax rate increases from 33 to 50%, the company goes from paying 4 to 6 in taxes (remember EBIT was 12).
Annual earnings to shareholders will thus be reduced by 2, but the multiple will stay the same. However, we can all agree that the company is now worth less to the shareholders.
Asset multiples: P/B ratio
In addition to the earnings multiples, there are a few helpful multiples based on asset values as well.
P/B is the most accessible of all multiples with numbers that are easy to find. It consists of the Price and the Book value of equity.
The Book value just lying there on the balance sheet, waiting for someone to lovingly pick it up and cuddle it. I’ve rarely seen it used, however.
The multiple may be suitable for companies in the financial sector, like banks or insurance institutions, but not for much else.
Asset multiples: The P/NAV multiple
This asset multiple consists of the Price, and the Net Asset Values. This means the real values of the company’s asset, less the net debt.
P/NAV is by far my favorite multiple, and in my opinion, superior to P/B.
Why don’t we use P/NAV all the time?
It’s pretty hard to find the exact value of the NAV. The company has to have assets that are frequently traded in the market. The pricing is supposed to reflect what you can get for the company if you have to liquidate and sell all the assets separately.
Many NAVs are just based on DCFs, which means they’re not really NAVs anymore. Then just using a simple Book value may be just as good, and more effective since you don’t have to calculate it yourself.
A stressor for true Net Asset Values
One common problem for all multiples based on liquidation of assets is that if your company is in a stressed financial situation, all the potential buyers may be as well.
The potential buyers usually operate within the same sector and would be affected by negative trends as well.
Which years should you use multiples for?
So should you use the multiple for this year’s earnings, next year, or maybe even the ear after that?
In general, all earnings in multiples are based on estimates. Some include the last year, then this year’s estimate, plus a year or two after. Estimates longer than that usually don’t make sense in most industries.
It’s important to note that multiples are supposed to show the company in a normal period and not in a particularly strong or week one.
One way to solve it if the industry suffers a downturn (like shipping for example often does), is to apply a “normalized” earnings multiple. Then to subtract or add additional value based on excess or too low cash flow the next few years.
Other more creative multiples
In addition to these classical multiples, you have tonnes of variations playing with companies cash flows, growth or adjusted asset values. Some sectors also mix in non-financial metrics, as Earnings/User or similar.
Anytime you use multiples, proceed with caution. Think about what affects the different multiples, and what would happen if they changed.
If you want to outperform in your investment§ banking interview, you need to know how all these multiples work.