We calculate the multiple from comparable publicly traded companies as follows:
Multiple = Share Price / Current Earnings
Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10. In stock market parlance, we'd say that XYZ is trading at ten times earnings.
We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples. This is a challenge, since no two enterprises are exactly alike. The uniqueness of every business is why valuation experts recognize their work as part science and part art. To examine this method further, let's return to our example firm.
Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares. But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size. We'll call one of these firms Acme Corporation. And let's suppose that Acme's P/E ratio is 8. Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8. This gives us confidence that our multiple of 8 is in the ballpark. With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.
Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:
Earnings x Appropriate Multiple = Equity Value
$347,500 x 8 = $2,780,000
Remember that this is the value of the company's equity. To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities. Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000. Thus, the value of the entire enterprise is as follows:
Enterprise Value = Equity Value + Value of Interest-Bearing Debt
$3,965,000 = $2,780,000 + $1,185,000
The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure. The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company. for this reason, it is essential that you factor out random and nonrecurring items. Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low. For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance. Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.
In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families. If these salaries have been unreasonably high or low, an adjustment of earnings is required. You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings. And while you're at it, take a hard look at the taxes that have reduced bottom-line profits. The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.
Multiple = Share Price / Current Earnings
Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10. In stock market parlance, we'd say that XYZ is trading at ten times earnings.
We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples. This is a challenge, since no two enterprises are exactly alike. The uniqueness of every business is why valuation experts recognize their work as part science and part art. To examine this method further, let's return to our example firm.
Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares. But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size. We'll call one of these firms Acme Corporation. And let's suppose that Acme's P/E ratio is 8. Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8. This gives us confidence that our multiple of 8 is in the ballpark. With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.
Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:
Earnings x Appropriate Multiple = Equity Value
$347,500 x 8 = $2,780,000
Remember that this is the value of the company's equity. To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities. Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000. Thus, the value of the entire enterprise is as follows:
Enterprise Value = Equity Value + Value of Interest-Bearing Debt
$3,965,000 = $2,780,000 + $1,185,000
The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure. The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company. for this reason, it is essential that you factor out random and nonrecurring items. Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low. For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance. Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.
In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families. If these salaries have been unreasonably high or low, an adjustment of earnings is required. You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings. And while you're at it, take a hard look at the taxes that have reduced bottom-line profits. The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.
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