Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

Price Multiples - Relative Valuation

Price multiples are ratios that compare the price of a stock to some sort of value.

Price multiples allow an analyst to evaluate the relative worth of a company's stock.

Popular multiples used in relative valuation include:

• price-to-earnings,
• price-to-sales,
• price-to-book, and
• price-to-cash flow.

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.

3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 

• liquidation value would be more useful for a company with losses that trades below book value, while 
• net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.

Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

PE multiple is rooted in discounting theory

Valuation using multiples has its fundamentals rooted in discounting.  It is a shortcut to valuation.

In this method, all factors considered in a general DCF including cost of capital and growth rates are compressed in one figure, namely the multiple figure.  Multiples are also market-based.


Let's look at PE in detail.

PE =  Price / Earnings

Price
= PE x Earnings
= Earnings / (1/PE)


Compare this with the time-value of money equation:

PV = FV / (1+r)^n

or the dividend growth model:

PV = Div1 / (r-g)


Thus a PE multiple of 5 should nearly imply a discount rate of 20%.

The same goes for other kinds of multiples used in the financial markets:
EV/EBITDA multiples
EV/Sales
Price/Cash flow.

They are all short cuts for discounting.  The EBITDA, Sales and Cash flows are all proxies of the free cash flow.

DEFINITION OF 'DISCOUNTED CASH FLOW - DCF'

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Also known as the Discounted Cash Flows Model.

Reference:  Finance for Beginners  by Hafeez Kamaruzzaman

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based:  The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based.  The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money.  The DCF method has many advantages, the most important being its future-looking orientation.  This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.

Finance for Managers - Earnings-Based Valuation - Earnings Multiple (2)

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.

Finance for Managers - Earnings-Based Valuation

Another approach to valuing a company is to capitalize its earnings.  This involves multiplying one or another income statement earnings figure by some multiple.  Some earnings-based methods are more sophisticated than others.  There is also the question of which earnings figure and which multiple to use.  

Valuing an asset using DCF and PER

Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. 


What 2 methods do you use to value assets?


1)  DCF


So too are valuing assets:discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.

But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.





2)  Price Earnings Ratio

Other tools are available to help you avoid this error. The price-to-earnings ratio (PER) is a regularly used proxy for stock valuation but also one of the most overused and abused metrics. To make use of it you need to know when to use it and when not to.

Related:

Price-Earning Ratio 101
http://myinvestingnotes.blogspot.com/2011/03/price-earning-ratio101.html

Introduction to Valuation - Videos

Valuation is the process of determining what something is worth. It is arguably the most important, and most difficult thing we do in finance.

This gives an introductory look at valuation from Discounted CashFlow Analysis (DCF) to market multiples (comparables).

Earnings multiplier of 2 equals 50% ROI.

What Is The Multiplier?

At times when I use the term “multiplier” or “multiple” as a business broker, many business owners screw up their faces and go “What?”. So I thought I might explain it here for your benefit.

The multiplier is the number of years it takes to recoup an investment in a business, based on the value of money today. For example, if I bought a business at $350,000 and EBIT (earnings before interest & tax) is $100,000 a year, then the multiplier for that business is the purchase price of the business divided by EBIT, which is 350K / 100K = 3.5x.

If we raise the profit to $150,000 a year, then the multiplier lowers to about 2.3x.

So a rule of thumb is – the smaller the multiplier, the more money it makes (and vice versa). But always keep in mind… if a business makes more money in a shorter amount of time, there’s probably a higher level of risk involved as well.

It’s Not All About Earnings!
However, the word “multiplier” need not only apply to earnings. It can also apply to sales, or to put another way, a business can be roughly appraised on its weekly or annual turnover. As an example, convenience stores are generally appraised on their weekly sales. So if a store does $15,000 a week, you might obtain a very rough indication of its value by multiplying it by 10 – the industry average in Queensland, Australia (as of October 2009). So an indicative price of the business might be $150,000.

So whenever you hear the word ‘multiplier’, you should clarify whether they’re talking about earnings or sales.

How About ROI or P/E?
You can also convert the earnings multiplier into a ROI (return on investment) figure by calculating 1 divided by the multiplier. So if you have an earnings multiplier of 2, 1 divided by 2 equals 50% ROI.

And also for all you share investors out there, the earnings multiplier is exactly the same as the P/E ratio (price earnings ratio).


http://www.businessforsaleblog.com.au/what-is-the-multiplier/

****Earnings Multiples by Aswath Damodaran

PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.

Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms

Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.

Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.


PEG Ratios and Fundamentals: Propositions

Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.

• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.

• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.

Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.

• Corollary 3: PEG ratios do not neutralize the growth effect.


Relative PE: Definition

The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.

Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.

Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.

The average relative PE is always one.

The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.


Read: 103 slides on earnings multiples
http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/earnmult.pdf

Valuation Methodologies

Despite their widespread usage, only limited theory is available to guide the application of multiples. With a few exceptions, the finance and accounting literature contain inadequate support on how or why certain multiples or comparable firms should be chosen in specific contexts. Compared to the DCF and RIV approach, standard textbooks on valuation devote little space to discussing the multiples valuation method.


Valuation Methodologies

This note provides an overview of the wide range of methodologies employed by Davy analysts when valuing shares.

One approach used is to apply average valuation multiples derived over multi-year periods, primarily with a view to smoothing cyclical effects.

Share-based multiples include:

Historic and forward price/earnings (P/E) ratios, based on normalised earnings before goodwill amortisation
Historic and forward price/cash-earnings (pre-depreciation) ratios
Price to net asset value per share
Dividend yields


Enterprise-based valuation multiples include:

Historic and forward earnings before depreciation, interest, tax, depreciation or amortisation (EBITDA) ratios; EBITDAR ratios are used where rental/lease charges (R) are material
Historic and forward EBITA ratios
Historic and forward operating cash-flow ratios
Enterprise value (EV)/sales ratios
EV/invested capital ratios
As enterprise values include net financial liabilities and minority interests, these are then deducted to arrive at the residual equity value.

Cyclical considerations
In the case of average earnings multiples, cognisance is given to the stage of the relevant industry cycle, as it may not be appropriate to apply average multiples towards the peak or trough of a cycle. In such cases, earnings multiples prevailing at the corresponding stages of previous cycles may be used.

Asset-based valuations
In the case of asset-based valuations, reported net assets generally provide a floor to a company's valuation. In many cases, however, company accounts can understate the underlying economic value of a company's assets, and a ratio such as return on invested capital to weighted average cost of capital (ROIC/WACC) may provide a more appropriate indicator of the book value multiple.

Company comparisons
The ratings of similar companies may be taken into account in valuing shares, as indeed may average ratings for particular industry sectors. Such ratings are commonly used in analysts' sum-of-the-parts (SOTP) valuations.

Cash-flow based valuation
In discounted cash-flow (DCF) models a company's forecast future free cash-flows are discounted by its weighted WACC. Due to the uncertainties involved in forecasting long-term cash-flows, analysts use a number of different DCF models.

Other valuation techniques
In some instances, other valuation metrics may be used. For instance, enterprise value per tonne of installed capacity may be used in capital-intensive sectors or in the earlier stages of a company's development.

http://www.davy.ie/Generic?page=valuationmethodologies

Fair market valuation of a business

Fair market valuation of a business

Table of earnings multiples for groups of industries
(choose the earnings multiple for the industry closest to the one you are valuing)

Very narrow profit variation - 10 times average earnings
Cosmetics; Food; Tobacco; Utilities

Moderately narrow profit variation - 9 times average earnings
Amusement; Beverages; Chemical; Container; Drug; Meat Packing; Oil; Paper / Paper Products; Retail Trade; Sugar; Textile

Moderately wide profit variation - 7 times average earnings
Advertising; Agricultural Impt.; Aviation; Boots and Shoes; Coal; Electrical Equipment; Household Products; Financial; Leather; Office Equipment; Printing; Publishing; Radio; Railroad; Rubber; Shipping; Ship Building

Very wide profit variation - 6 times average earnings
Automobiles; Automobile Accessories; Construction; Machinery; Non-Ferrous Met.; R.R. Equipment; Steel



http://www.investordesktop.com/calcs/calcs/busins_fmvb_tbl.htm

Price to earnings ratio (P/E ratio) explained

Price to earnings ratio (P/E ratio) explained
by Kenneth W. McCarty

Price to earnings ratio (P/E ratio sometimes referred to as the multiple) is the current price per share divided by a years worth of earnings per share (EPS) for a particular stock. It is an important indicator of perceived value for a stock. Often it is used to compare two different stocks in the same sector (or two sectors in a given market) in an effort to find the better "deal". It sounds simple enough, but in practice it is a bit more complicated.

Not all publicly traded companies have earnings (they can have losses instead), yet these stocks clearly have value. P/E in such circumstance cannot be relied upon when it is negative or undefined. Much more important for estimating the current value of this type of equity are such things as cash on hand and other tangible assets. Some investors may anticipate that the stock will eventually have real earnings and add perceived value to the stock based on this assumption.

A backwards or "trailing" P/E takes into account only the earnings for the past year. In a "Bull Market", this form of P/E can be considered an indicator for the floor of a stock's share price. Instead of estimates, the earnings stated in the last 4 quarterly reports are publicly known and are generally not subject to change at a whim (except when future reports become current or the company is forced to make restatements by the SEC or an unfavorable audit).

Many investors prefer to use a forward P/E instead. This speculative potential of the stock's perceived worth that may or may not be added into the price anticipates and uses earnings over the next 12 months. Market forces determine how reliable such calculated predictions are and adjust prices accordingly. Company track records and economic influences are used by traders to judge the reliability of those numbers.

The difference between the two values that forward and backward P/E represent helps create volatility in the price of the stock as traders try to forecast earnings. Different stocks trade over different ranges of multiples for a variety of reasons. Many stocks in mature industries historically tend to trade between multiples of 10 and 20. Technology stocks that have real earnings often trade between multiples of 20 and 40. A company that has significant revenue growth may deserve a much higher multiple than this because the implication is that notable future earnings growth will continue to occur. When track records for 10Q quarterly reports are consistently positive, investors tend to follow the idea that solid companies under good management will continue to notify the market of future earnings growth. Investors like to trade on trends because "the trend is your friend".

When traders and investors on the market either become extremely pessimistic or optimistic, historical range standards for P/Es generally do not hold true over the short-term. During the height of the stock bubble of 1999 and 2000, too many stocks traded with ratios over 500! Such imbalances are eventually corrected and that is what happened. Knowing the historical standards gives us insight into why those stock prices eventually crashed so abruptly and steeply. The trend could no longer continue.

In contrast, currently there is a dramatic pessimism depressing prices in the stock market (since November of 2007). I've seen a number of technology stocks trade with a backward P/E of 10 or lower. Certainly in this financial environment a P/E of around 15 seems common for even a technology stock! Some might even consider the trend justified because of the implications inherent from a failing sub-prime loan market. Yet these P/E ratios are far below the historic average even in the worst of times.

Even more unusual is that some of those same stocks are experiencing record breaking increased earnings with projected significant earnings growth - despite the continued horrendous condition of the financial sector. Some of these stock's earnings performance over the last 6 to 9 months have even been better than the most optimistic expectations. Yet a few of these top performers have had their price cut nearly in half with little to no recovery! Clearly there are forces other than just P/E ratios and growth potential at work when the market determines the worth of a given stock at any given time. Part of my job as a trader is to ask why this is happening at this particular time and respond appropriately. Keep in mind that history tells us a significant correction to the upside is inevitable once investors recognize the "good deals" available.


http://www.helium.com/items/1082973-what-is-pe-ratio

WHAT DOES PE RATIO TELL YOU?

WHAT DOES IT TELL YOU?

The P/E ratio gives us an idea of how much the investors are willing to pay for the company's earnings. The higher the P/E, more the chances of good earnings in the future and the higher premium investors are ready to pay for that anticipated growth. A lower ratio on the other hand means just the opposite; that the market has ruled out the company.

But just because the ratio is very high or very low cannot help investors to make a decision. A high P/E can also be an overpriced stock. Also if one stock has double the P/E of another stock in the same industry, but with the same rate of earnings growth, it is not seen to be a wise investment as more money has to be shelled out. A low P/E ratio may be a market that was overlooked. The investors who discover the true worth of such stocks make big fortunes overnight.

There are various interpretations for the P/E value and this is just one of them:
*N/A: A company with no earnings has an undefined P/E ratio. Companies with losses or negative earnings also fall under this category.
*0-10: This means that the company's earnings are declining. It could also mean an overlooked stock.
*10-17: This is the average healthy value
*17-25: This means that the stock is either overvalued or its earnings are increasing.
*25+: Such companies are expected to have high future growth in earnings.


It is important that investors note avoid basing a decision on this measure alone. The ratio is dependent on share price which can fluctuate according to changes in the market.

http://www.helium.com/items/1059698-price-to-earnings-ratio-pe-ratio-explained

Demystifying Small Business Valuation

Demystifying Small Business Valuation
Valuing a business is based on return on your investment (ROI). The value of a Business for Sale does not need to be subjective and can be based on several attributes and industry best practices.





Approach to Business Valuation

Valuing businesses is of paramount importance to a small business. It is one of the several metrics used to ensure the business is growing and creating value for the owners. There are several approaches to valuing a business including:

• Revenue Multiples
Earnings Multiples (including EBITA and operating income)

• Multiple of Book Value
Multiple of a measured unit (Like Restaurant tables, hospital beds, subscribers and more)

Rules of thumb are used by business brokers to ascertain the price of a business and simplify the valuation process. However, one must be mindful that the values determined using “Rule of thumb” are simplifications and only an estimate of the true value of the business. The “Rule of thumb” approach is used as a staring point before conducting detailed due-diligence to ascertain the correct value. Some examples of “Rules of thumb” used in the industry are listed in Table 1 below:


Table 1: Rules of Thumb Valuation



Type of Business “Rule of Thumb” valuation

Book Stores 15% of annual sales + inventory
Coffee Shops 40% - 45% of annual sales + inventory
Food/Gourmet Shops 20% of annual sales + inventory
Gas Stations 15% - 25% of annual sales + equip/inventory
Restaurants (non-franchised) 30% - 45% of annual sales
Dry Cleaners 70% - 100% of annual sales



A common approach to valuing a business is to use earnings or sales multiples. In this case since the price it is derived from annual earnings or sales and it directly addresses a buyer’s motive of estimating the return on investment (ROI) on deals.

When using earnings multipliers, it is inappropriate to get the multiples from Real Estate or Stock Markets. Real Estate is historically priced at 8 to 10 times its net operating income (EBITA). Stock markets are typically priced at 12 to 20 times earnings. These multiples do not apply to small businesses as the risk premium associated with a small business is much higher than managing a building or a stock portfolio.

Therefore, the first step in using the earnings multiplier approach is to determine which earnings multiplier is to be used. For example, one could use the current earnings, next year’s earnings or last 5 years earnings averaged. Other factors to consider include determining the composition of earnings. Do we need to calculate earnings after owner’s pay and perks, interest expenses, depreciation and taxes? The preferred earnings to use are 'Earnings before Interest and Taxes’ (EBIT).

Normalized earnings are adjusted for cyclical ups and downs in the economy. They are also adjusted for unusual or one-time influences. For small businesses normalized earnings projections are quite useful.

Finally we need to determine the multiplier. The number picked for multiplier is based on risk and there usually are “Rules of Thumb” multiplier numbers depending on the industry.

Using a multiplier with annual sales is also a common approach. For example, the “Rule of thumb” for a coffee shop is 40% - 45% of annual sales + inventory.


Tangible and Intangible assets

A tangible asset is an asset that has a physical form such as land, buildings and machinery. Intangible assets are the opposite of tangible assets. Intangible assets include patents, trademarks, brand value etc. Tangible and intangible assets raise interesting questions when valuing a business.

Typically once the value of the business itself has been ascertained, we need to factor in a value for Tangible and Intangible assets. These assets usually have a value separate from the business. One way to determine if an asset should be included as a tangible/intangible asset or included in the price for the business is to determine if the asset was used to generate the projected earnings. If the asset was used to generate earnings it should be included as a part of the multiple derived price of the business.

Factoring in tangible assets separately is especially true for businesses that own land and buildings, as these assets can be sold in the market even if the business failed. Therefore the best way to treat tangible/intangible asset is to separate them from the business and then add them back to the multiple derived value of the business. Obviously during the valuation period, asserts should not be counted twice. For example if the building has been factored out as a tangible and intangible asset, then rent for the premises must be subtracted from the business earnings. Similarly inventory impacts the business value. Typically inventory is valued at cost and treated as a tangible asset.


Earnings Multiples

After the value of tangible and intangible assets is determined we need to determine the value of the business using the correct multiples. Multiples used are very specific to a business and location of the business but broadly speaking it can be between 2 to 5 times normalized EBIT (Earnings before Interest and Taxes). The business can be worth more if it is has distinctive attributes that make it very attractive. To the buyer, 2 to 5 times earnings represent getting back their investment in the business in 2 to 5 years from profits a projected annual return of 20% to 50%.

Eventually the right multiple is the amount the buyer is willing to pay for the business. A business can demand higher multiples by clearly defining a case to increase earnings over time.


Disadvantages and caveats

Based on the content covered earlier, you may wonder how one can be certain the business valuation is perfect for the business buyer and seller. In reality there is no perfect price and techniques described in the earlier sections are just guidelines to derive an acceptable price.

The multiplier approach discussed does not provide sufficient information to assess the uniqueness of the business, such as management depth, customer relationships, industry trends, reputation, location, competition, capital structure and other information unique to the business. Further, two businesses of the same type and same revenue can have different cash flows.

The rules for evaluating a business are more of guidance then a hard and fast rule. They should be thought of as a starting point which can be further refined by factors specifically impacting the business. Proper evaluation will go beyond calculations based on multiples and tangible/intangible asset values. It requires complete business, marketing and financial due-diligence. However the approach describes in this article can play a key role in determining a starting value of your business.

Sites such as http://www.buysellbusiness.org allow entrepreneurs to do deals by buying and selling businesses and partnering. When researching businesses for deals, these guidelines can play an important role in quickly calculating the intrinsic value of a business.


http://www.buysellbusiness.org/BusinessTools/BizValuations.aspx

Valuation: What's it worth?

What's it worth?
Although there are several formulas you can use, there are no black-and-white answers on valuation techniques.

It’s important to conduct your own research, then get independent advice from a business valuer or broker. Here are four of the most commonly used valuation methods.

Method 1: Asset valuation
Method 2: Capitalised future earnings
Method 3: Earnings multiple
Method 4: Comparable sales

Method 1: Asset valuation
This approach determines the value of a business by adding up the value of its assets and subtracting liabilities. It tells you what the business would be worth if it were closed down today and its assets sold off, but it doesn’t take into account the ability of those assets to generate revenue in the future. For that reason, it may understate the true value of the business.

How it works

1.Add up the value of all the assets such as cash, stock, plant and equipment and receivables.
2.Add up liabilities, such as any bank debts and payments due.
3.Subtract the business’ liabilities from its assets to get the net asset value.


Example
Richard wants to buy a manufacturing business. Here’s an extract from the business’ balance sheet.

With assets of $300,000 and liabilities of $200,000, the net asset value of the business is $100,000.

What about goodwill?
This method doesn’t include a value for goodwill or the right to earn future profits, so it may understate the true value of a business. Goodwill is the difference between the true value of a business and the value of its net assets. It can be crucial to the value of retail and service-based businesses.

For example, when you are valuing a business such as a hairdressing salon, where the standard of service, location and reputation are important, the value of any goodwill would have to be added to net assets to get a valuation.

You need to consider whether goodwill can be transferred when you buy the business. While goodwill can come from physical features such as location, it can also arise from personal factors, such as the owner’s reputation or their relationships with customers or suppliers, which may not be transferable.

And if the business is underperforming and there is no goodwill attached to it, then using the net assets valuation method could be an accurate way of determining its value.



Method 2: Capitalised future earnings
When you buy a business, you’re not only buying its assets. You’re also buying the right to all of the profits that business might generate. Different valuation methods try to capture that.

Capitalising future earnings is the most common method used to value small businesses. The method looks at the rate of return on investment (ROI) that you can expect to get from the business.

How it works

1.Work out the average net profit of the business over the last three years using its profit-and-loss statements. You’ll need to adjust the profit for any one-off expenses or other irregular items each year.
2.Decide the annual rate of return that you’re looking for as a business owner (for example, 20%). There are no hard and fast rules about what number you should choose, except that the higher the risk, the higher your return should be. A good starting point is to compare the business with other investment opportunities — everything from safe havens like term deposits, to riskier investments like shares. You can also look at the rate of return that similar businesses in the same industry achieve.
3.Divide net profits by the rate of return to determine the value of the business, then multiply by 100.


Example
David is looking at buying a bakery business with average net profits of $100,000 per annum after adjustments. David wants an annual rate of return of 20%. The capitalised earnings valuation is:

Method 3: Earnings multiple
If you invest in shares, you might already be familiar with this method, since it’s often used to assess the value of companies whose shares are traded on a stock exchange and therefore reflect market expectations. But it can be used to value unlisted businesses.

Its big advantage is its simplicity. The difficulty lies in deciding which multiple to use.

How it works
Simply multiply the business’ earnings before interest and tax (EBIT) by your selected multiple. For example, you might value the business at twice its annual earnings — so a business with an EBIT of $200,000 might be valued at $400,000.

The multiple you choose will depend on the industry and the growth potential of the business. A service-based business might be valued at as little as one year’s earnings, while an established business with sustainable profits might sell for as much as six times earnings. (Listed companies trade at much higher multiples, because their size and liquidity makes them less risky investments.)

This method can be useful for valuing a business where there are regular sales of similar businesses to help you determine an objective earnings multiple. A business broker should be able to tell you this.



Method 4: Comparable sales
Whatever other valuation method you use, you should also look at prices for recent sales of similar businesses. Like buying a house, it makes sense to know what is happening in the market in which you’re interested.

Speak to a few business brokers and gauge their feeling about the business’ value. They might know what similar operations are selling for and how the market is placed at that particular time. Check business-for-sale listings in relevant industry magazines, newspapers or websites.



Tools and templates

Buying a business checklist

Important information
As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on the advice, consider its appropriateness to your circumstances. All products mentioned on this web page are issued by the Commonwealth Bank of Australia; view our Financial Services Guide (PDF 59kb).

http://www.commbank.com.au/business/betterbusiness/buying-a-business/whats-it-worth/

How is a P/E multiple used?

The Price/Earnings Multiple Enigma

If the Price to Earnings Multiple (P/E) were to be judged by usage, it wins hands down compared to any other valuation metric. It is easy to compute, can be applied across companies and across sectors, with a few exceptions. What is this ratio, how is it computed, and how to use it are questions to which you will find answers in this section.

What is a P/E multiple?
The P/E multiple is the premium that the market is willing to pay on the earnings per share of a company, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E is calculated by dividing the current market price of a company's stock by the last reported full-year earnings per share (EPS). In effect, the ratio uses the company's earnings as a guide to value it. The P/E thus computed is also known as the trailing or historical P/E since it uses the trailing (historical) EPS in its calculations. With the advent of quarterly results, it is also possible to compute P/E, based on the earnings of the latest four quarters’ EPS. This is known as trailing twelve months P/E.

A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the effort to factor in the expected growth of a company.

Since stock market valuations factor in the future expectations of the market, a P/E multiple computed using historical earnings can at best be of academic value since it does not factor in the future growth in earnings. It fails to capture events that may have happened after the earnings date. For example, suppose a merger happens after the earnings have been declared, a P/E multiple based on the historical P/E will fail to capture this event in the EPS whereas the price would reflect it, creating a distortion.

The forward P/E is popularly used to find out if the premium the market is willing to pay on the earnings is line with the growth expectations. For example, the market price of Stock A is Rs 1,000, with a P/E multiple of 30 based on historical earnings. Assuming an earnings growth of 50%, the one year forward P/E changes to 20, which means the market is willing to pay 30 times its historical earnings and 20 times its one-year forward earnings.

For an investor it makes much more sense to look at the forward P/E for taking an investment decision. Each investor would have his or her own expectations regarding the future earnings growth. To that extent the forward P/E for a particular stock will vary from investor to investor.



How is a P/E multiple used?
P/E multiples reflect collective investor perception regarding a company's future. This perception is a function of various factors, like industry growth prospects, company’s position in industry, its growth plans, quantum change expected in sales or profit growth, quality of management, and other macroeconomic factors like interest rates and inflation.

Is a stock trading at a P/E of 30 more expensive than a stock trading at a P/E of 60? Such a wide variation in P/E multiples can be owing to a few reasons. If the companies are in the same industry, it could be that the company with a high P/E may be one with superior size and financials, with better prospects or even better management. The market expects this stock to outperform its peers. If they are from different industries, it could also be due to different growth prospects. For example, an energy utility will have a more sedate earnings profile than say a software company.

Besides different expectations regarding future earnings growth, some of the difference in P/E can also be attributed to the disclosures made by the management to their shareholders. Hence, qualitative factors like transparency, quality of management also impact a stock's P/E.

Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They have to be viewed along with the company's future prospects to arrive at any conclusion. Generally, higher the expected growth in a company's earnings, higher is the P/E multiple that it attracts in the market. The time period used for P/E calculations depends on the investment horizon of the investor and would be different for each investor. However, P/E multiples cannot be applied to loss making companies since they do not have any earnings.


Price to Earnings Growth Multiple (PEG)
The PEG multiple takes the P/E analysis to the next stage. Since P/E ratios are computed based on historic earnings, they project an inaccurate picture of the future. The PEG multiple uses expected growth in earnings, to give investors additional information. The PEG divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the compounded earnings growth is calculated using the forecasted earnings for the next two-three years.

For example, if a company is quoting at a P/E of 60 based on historic earnings and the compounded annual growth rate of its earnings for the next three years is 20 per cent, then its PEG is 3.

The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a stock on a multiple of 50 whose earnings are growing at 20 per cent. As a thumb rule, stocks quoting at a PEG multiple below 0.5 are considered to be undervalued, 1 to be fairly valued, and 2 to be overvalued.


http://www.hdfcsec.com/KnowledgeCenter/Story.aspx?ArticleID=8153321b-8faa-4429-abba-bbfe5f29e77d

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.


http://www.dilanchian.com.au/index.php?option=com_content&task=view&id=166&Itemid=148

A Crash Course on Earnings Multiples

A Crash Course on Earnings Multiples


As a trusted business advisor you’ve probably heard former business owners telling people that they sold their business for “six times earnings.” As investment bankers, the first question we hear from prospective clients is “Can I get the same multiple if I sell my business?” The answer is an unequivocal "it depends." It depends on a number of things, but first and foremost, it depends on how you define “earnings”.

As all investment bankers and sellers know, “Cash is King.” After all, cash removes the seller’s risk in the transaction. However, when a buyer pays cash for a business, that buyer wants to know exactly how much the business is earning.

Let’s start with what seems to be a pretty basic concept: earnings.



The Definitions of Earnings

There are several definitions of earnings; each is potentially different from the other depending on the type of company and the way its owner runs the company. Typical measures of earnings include:

§ Net Operating Income: This is sales less the cost of goods sold and operating expenses.

§ Pre-tax Income: This is net operating income plus non-operating income (like interest on notes, etc.) less non-operating expenses (like one-time, non-recurring expenses).

§ After-tax Income: Pre-tax income, less all company (but not individual) taxes.

§ EBIT: This stands for earnings before interest and taxes.

§ EBITDA: This stands for earnings before interest, taxes, depreciation and amortization


Add to these measures, the need to “adjust" earnings by deducting capital expenditures, and adding back excess rents, excessive salary and bonuses paid to the owner and his or her family. The result is something called:

Owner’s Discretionary Cash Flow or True Cash Flow: This is the amount of pre-tax money distributed to owners via salary, bonus, distributions from the company such as S-distributions, and rental payments in excess of fair market rental value of the equipment or building used in the business. This provides buyers with the most accurate indicator of how much “cash” a company can actually produce and is often the most meaningful indicator of value.

Which brings us back to our original question: Is it realistic for a business owner to expect a six times multiple when he sells his business? There is no one right or wrong answer to this question.

To show you how tricky this can be, let’s look at a former client of ours. His business was not doing well. He had revenues of approximately $7 million but, even using the most generous definition of earnings, the company was not earning more that about $100,000 per year. We ultimately sold the company to a buyer of distressed companies who paid book value for its assets or about $2 million. Despite this low value, our client was extremely happy because his business sold for 20 times earnings! In this case the buyer was buying assets, not earnings, so an earning multiple wasn’t even appropriate.

To determine which measure of earnings is appropriate for a business, you need to look first at how the seller’s industry defines “earnings”. This "earnings" measure reflects how much a buyer can afford to pay for the business. The actual multiple applied will be based on:

§ which definition of cash flow is being used,

§ what is appropriate for a given industry,

§ what the company’s specific growth prospects are,

§ how the company’s earnings compare with similar companies in the same industry, and finally

§ how the company’s earnings compare with the company’s asset value.

Richard E. Jackim, JD, MBA, CEPA is the author of the critically acclaimed book, “The $10 Trillion Opportunity: Designing Successful Exit Strategies for Middle Market Business Owners”, available at http://www.exit-planning-institute.org/


http://www.imakenews.com/epi_hfco/e_article001197834.cfm?x=bdnqbsy,w