Business valuation with price earnings multiples

Business valuation with price earnings multiples

Tuesday, 12 December 2006 02:45 Anton Joseph
E-mail | Print | Tags: valuation | business sale/purchase | ip revenue | strategy

When it comes to selling or buying a business the sale price is the greatest obstacle and point of disagreement in many transactions. If there is a reasonable and easily understandable way of determining the value of the business the parties can quickly progress more than half way through the sale process. Although it is said that the right tools must be used to value businesses, no simple method suits all types of businesses. Instead, there are several financial and non-financial performance indicators that are commonly used by businesses to monitor their progress. Some are used to measure profitability whilst others are used to test liquidity.

Financial indicators are normally measured by using ratios calculated using numerical values appearing in the profit and loss account or the balance sheet. Since the indicators are snapshot calculations based on historical figures (figures for the past year), there is an understandable reluctance to always rely on them. This is especially so when a small business is examined for its value for sale.

A prudent business seller or buyer can use financial indicators (such as industry conventions, multiples and ratios) as part of a toolkit to negotiate an acceptable business sale price. One indicator is a price earnings multiple. Elsewhere we have examined business valuation with EBIT multiples.

PE multiple or PE ratio definition

A price earning multiple (PE multiple) is used mostly to estimate the performance of companies whose shares are traded in public and therefore reflect market expectation to a credible extent. The PE multiple of a share is also commonly called its "PE ratio", "earnings multiple", "multiple", "P/E", or "PE").

The PE multiple method, while unorthodox for small and medium-sized businesses, may provide a useful indicator of the value of a business for sale purposes.


Examples of use of PE multiples in Australian business

You can achieve better outcomes as a seller or buyer if you properly prepare for and anticipate positions that various interested parties might hold during the negotiation dance that takes place for a business sale, purchase, takeover, merger or acquisition. It is useful to study prior transactions and to keep a close watch on market developments. Here are recent examples illustrating the use of PE multiples in media commentary, research reports and takeover documents.

Wealth Creator Magazine in its Sep/Oct 2006 issue reviews "hot" stocks in the 2006-07 financial year. In its commentary it says John Fairfax Holdings Ltd (ASX code: FXJ) "...is currently trading on a price earnings of 16 x and provides a yield of 4.5% fully franked..." and Fosters Group Ltd (ASX code: FGL) "...is trading at a price earnings multiple of 15.6 x 2006 earnings, which we believe is reasonable earnings, reduced gearing and upside potential as the cycle improves."

Intersuisse Ltd in an investment research statement dated 24 August 2006 makes a buy recommendation about BHP Billiton (ASX code: BHP) concluding: "We believe the depth and quality of the company's earnings are such that the stock deserved to be placed on a higher price/earnings (p/e) multiple than the prospective p/e of 10.4 times for FY07 and 9.8 times for FY08 and that multiples of at least 12 to 14 times would be more appropriate."

In an Independent Expert's Report Grant Samuel & Associates Pty Ltd assesses the takeover bid by Rank Group Australia Pty Ltd for Burns, Philp & Company Ltd. Grant Samuel states (at its page 18):

"Capitalisation of earnings or cash flows is the most commonly used method for valuation of industrial businesses. This methodology is most appropriate for industrial businesses with a substantial operating history and a consistent earnings trend that is sufficiently stable to be indicative of ongoing earnings potential. This methodology is not particularly suitable for start-up businesses, businesses with an erratic earnings pattern or businesses that have unusual capital expenditure requirements. This methodology involves capitalising the earnings or cash flows of a business at a multiple that reflects the risks of the business and the stream of income that it generates. These multiples can be applied to a number of different earnings or cash flow measures including EBITDA, EBIT or net profit after tax. These are referred to respectively as EBITDA multiples, EBIT multiples and price earnings multiples. Price earnings multiples are commonly used in the context of the sharemarket. EBITDA and EBIT multiples are more commonly used in valuing whole businesses for acquisition purposes where gearing is in the control of the acquirer."




How to calculate the PE multiple for your business

The PE multiple method is the most commonly used earnings capitalisation methodology. It appears in the following two equations:

1.Total value of business = PE multiple x net profit after tax (NPAT)
2.Value per share = PE multiple x earnings per share

The above two equations can be used to provide some indication of the value of a business. First, using the second equation, dividing the market price of a share by the earnings per share you will be able to calculate the PE multiple for the business. Then by multiplying the PE multiple by NPAT a value for the business can be determined.

With a public company, assume the market value of a share of the company is $35 and the earnings per share is $5, then the PE multiple is 25 divided by 5 which is 7. If the NPAT is $110,000 then the value of the business is $110,000 multiplied by 7, which is $770,000.

As a first step in using the above method, one needs to find a listed company carrying on a business similar to the business of the company to be valued. Next, obtain a copy of the most recent financial statements published by the company, from which the NPAT and EPS of the company can be obtained. Now obtain the recent price quoted for the shares in the company from its Website or the ASX Website.

EPS is a measure of the amount of profit that can be attributed to ordinary shares in the company. If the financial statements of the company do not provide the EPS, it can be calculated by dividing NPAT (after deducting NPAT attributable to any outside equity interests, such as preference shares and any payments made to such outside equity interests) by the total number of ordinary shares on issue. The total number of shares on issue can be got from the balance sheet of the company.

If the PE multiple of the company selected is high it can mean that the shares of the company are overpriced and yet the market is expecting a high return in the future. This could be for several reasons, such as potential for growth in the overseas market or even a change of the CEO. Similarly the PE multiple could be low and the shares underpriced because the company selected is about to be brought under a strict regulatory regime by the Government or it has lost a crucial licence. What is suggested here is that the PE multiple calculated using a typical company in the industry may not totally reflect the situation of the business under review.



PE multiple caution

Since the PE multiple method of valuation is dependent on factors that are approximations, consideration of other relevant performance ratios is recommended, eg dividend per share, dividend yield, dividend cover, net tangible assets per share and cash flow per share.

Ultimately working out the PE multiple is a job for a specialist or professional. It is not a job for a lawyer. It is also not a job for a non-financial business executive who is not properly briefed. But it is useful for everyone to be aware of how the numbers are derived.


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