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
Thursday, 12 November 2009
New Approach to Uncertainty in Business Valuations
- applying a premium or discount to a capitalization rate, or
- adjusting future revenue and
- adjusting future expense projections.
Thomas E. McKee, CMA, CIA, PhD, CPA, is a visiting professor in the department of accounting and legal studies at the College of Charleston, Charleston, S.C.
The earnings multiple valuation method
The earnings multiple valuation method
The earnings multiple valuation method is the preferred valuation method for most situations. It represents what someone would pay if you tried to sell under normal conditions, which is arguably the most appropriate valuation method for private equity investments.
In the broad strokes, this method entails applying an industry-based multiple to the earnings of a business to arrive at an implied enterprise value. From this enterprise value, subtracting net debt gives the equity value. In simple scenarios (involving only ordinary equity), a private equity firm’s relevant investment value is equal to their proportional stake in the investee’s equity.
The subjectivity of this method comes in the following forms:
•Do you use last year’s actual earnings number? Do you use a forecast? If so, whose forecast do you use? And what earnings are we talking about: NPBT, NPAT, EBIT, EBITDA? What about the effect of non-recurring costs, contributions from discontinued business units, forecast acquisition synergies, etc?
•What is an appropriate multiple? Are transactions from six months ago reasonable comparisons? Should I only use transactions from the same industry as comparables? What about company size: should I only compare those of similar size? What if there haven’t been any transactions for 12 months (this is especially applicable now)? Should I use the mean, mode or median of comparable transactions?
There are a lot of questions there and not many answers; it really depends on how honest you want to be with yourself and the limited partners. Here are my suggestions:
•Earnings - You should use the earnings number that you expect at the time of reporting. For example, this may be the current year’s EBIT forecast adjusted for the latest actual earnings figures (that is, if you were below budget, adjust the forecast months accordingly). If the trend is towards using the previous year’s earnings, then you should follow suit.
•Multiple - In the current climate, you may need to look outside your industry for trends, but also make sure to look for similar sized transactions. There’s no perfect multiple to use, but there’s certainly a range that will seem reasonable. I’d say in the current environment that anything over 8-10x would be unreasonable. For mid-market deals, I wouldn’t expect to see multiples over 6-7x, unless there is a strong case for exceptional growth. It may surprise you, but I’m seeing some interesting deals go for 3x now.
You’ll know in your own mind whether you’re being fair with your analysis. Try not to cheat yourself because there’s a real danger that it could come back to haunt you. There’s always the argument that if things really do get better, investors will be glad to see a significant uptick in your next report. If you’re too optimistic now, disappointing them twice will hardly be fun. Also, investors won’t be surprised with value losses now; they’re probably expecting them. So take this opportunity to take an honest look at your portfolio and move on to planning for the upturn (now there’s some positive thinking).
http://www.theprivateequiteer.com/the-earnings-multiple-valuation-method/
The earnings multiple valuation method is the preferred valuation method for most situations. It represents what someone would pay if you tried to sell under normal conditions, which is arguably the most appropriate valuation method for private equity investments.
In the broad strokes, this method entails applying an industry-based multiple to the earnings of a business to arrive at an implied enterprise value. From this enterprise value, subtracting net debt gives the equity value. In simple scenarios (involving only ordinary equity), a private equity firm’s relevant investment value is equal to their proportional stake in the investee’s equity.
The subjectivity of this method comes in the following forms:
•Do you use last year’s actual earnings number? Do you use a forecast? If so, whose forecast do you use? And what earnings are we talking about: NPBT, NPAT, EBIT, EBITDA? What about the effect of non-recurring costs, contributions from discontinued business units, forecast acquisition synergies, etc?
•What is an appropriate multiple? Are transactions from six months ago reasonable comparisons? Should I only use transactions from the same industry as comparables? What about company size: should I only compare those of similar size? What if there haven’t been any transactions for 12 months (this is especially applicable now)? Should I use the mean, mode or median of comparable transactions?
There are a lot of questions there and not many answers; it really depends on how honest you want to be with yourself and the limited partners. Here are my suggestions:
•Earnings - You should use the earnings number that you expect at the time of reporting. For example, this may be the current year’s EBIT forecast adjusted for the latest actual earnings figures (that is, if you were below budget, adjust the forecast months accordingly). If the trend is towards using the previous year’s earnings, then you should follow suit.
•Multiple - In the current climate, you may need to look outside your industry for trends, but also make sure to look for similar sized transactions. There’s no perfect multiple to use, but there’s certainly a range that will seem reasonable. I’d say in the current environment that anything over 8-10x would be unreasonable. For mid-market deals, I wouldn’t expect to see multiples over 6-7x, unless there is a strong case for exceptional growth. It may surprise you, but I’m seeing some interesting deals go for 3x now.
You’ll know in your own mind whether you’re being fair with your analysis. Try not to cheat yourself because there’s a real danger that it could come back to haunt you. There’s always the argument that if things really do get better, investors will be glad to see a significant uptick in your next report. If you’re too optimistic now, disappointing them twice will hardly be fun. Also, investors won’t be surprised with value losses now; they’re probably expecting them. So take this opportunity to take an honest look at your portfolio and move on to planning for the upturn (now there’s some positive thinking).
http://www.theprivateequiteer.com/the-earnings-multiple-valuation-method/
Earnings Multiple: A Valuation Method
Among various methods for determining the value of a small business, the "earnings multiple" approach is almost universally considered to be the most acceptable and useful.
- on the one hand--a manufacturing company in a troubled industry with several hundred thousands in hard assets, but less than $3,500 per month in owner earnings, and
- on the other hand, a distributorship generating more than $20,000 per month in owner earnings, and operated successfully with little in the way of assets--perhaps just a fax-capable telephone and an address book.
http://www.usabizmart.com/blog/earnings-multiple-business-valuation-120508.php
Price to Future Earnings
Price to Future Earnings
The price earnings ratio cannot be estimated for firms with negative earnings per share. While there are other multiples, such as the price to sales ratio, that can still be estimated for these firms, there are analysts who prefer the familiar ground of PE ratios.
One way in which the price earnings ratio can be modified for use in these firms is to use expected earnings per share in a future year in computing the PE ratio.
For instance, assume that a firm has earnings per share currently of -$2.00 but is expected to report earnings per share in 5 years of $1.50 per share. You could divide the price today by the expected earnings per share in five years to obtain a PE ratio.
How would such a PE ratio be used? The PE ratio for all of the comparable firms would also have to be estimated using expected earnings per share in 5 years and the resulting values can be compared across firms. Assuming that all of the firms in the sample share the same risk, growth and payout characteristics after year 5, firms with low price to future earnings ratios will be considered undervalued.
An alternative approach is to estimate a target price for the negative earnings firm in five years, divide that price by earnings in that year and compare this PE ratio to the PE ratio of comparable firms today.
While this modified version of the PE ratio increases the reach of PE ratios to cover many firms that have negative earnings today, it is difficult to control for differences between the firm being valued and the comparable firms, since you are comparing firms at different points in time.
Illustration: Analyzing Amazon using Price to Future Earnings per share Amazon.com has negative earnings per share in 2000. Based upon consensus estimates, analysts expect it to lose $0.63 per share in 2001 but is expected to earn $1.50 per share in 2004. At its current price of $49 per share, this would translate into a price/future earnings per share of 32.67.
In the first approach, this multiple of earnings can be compared to the price/future earnings ratios of comparable firms. If you define comparable firms to be e-tailers, Amazon looks reasonably attractive since the average price/future earnings per share of etailers
is 65. If, on the other hand, you compared Amazon’s price to future earnings per share to the average price to future earnings per share (in 2004) of specialty retailers, the picture is bleaker. The average price to future earnings for these firms is 12, which would lead to a conclusion that Amazon is over valued. Implicit in both these comparisons is the assumption that Amazon will have similar risk, growth and cash flow characteristics as the comparable firms in five years. You could argue that Amazon will still have much higher growth potential than other specialty retailers after 2004 and that this could explain the difference in multiples. You could even use differences in expected growth after 2004 to adjust for the differences, but estimates of these growth rates are usually not made by analysts.
In the second approach, the current price to earnings ratio for specialty retailers, which is estimated to be 20.31, and the expected earnings per share of Amazon in 2004, which is estimated to be $1.50. This would yield a target price of $30.46. Discounting this price back to the present using Amazon’s cost of equity of 12.94% results in a value per share.
= Target price in five years / (1+ Cost of equity)^5
Value per share
= 30.46 / (1.1294^5)
= $16.58
At its current price of $49, this would again suggest an over valued stock. Here again, though, you are assuming that Amazon in five years will resemble a specialty retailer today in terms of risk, growth and cash flow characteristics.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
The price earnings ratio cannot be estimated for firms with negative earnings per share. While there are other multiples, such as the price to sales ratio, that can still be estimated for these firms, there are analysts who prefer the familiar ground of PE ratios.
One way in which the price earnings ratio can be modified for use in these firms is to use expected earnings per share in a future year in computing the PE ratio.
For instance, assume that a firm has earnings per share currently of -$2.00 but is expected to report earnings per share in 5 years of $1.50 per share. You could divide the price today by the expected earnings per share in five years to obtain a PE ratio.
How would such a PE ratio be used? The PE ratio for all of the comparable firms would also have to be estimated using expected earnings per share in 5 years and the resulting values can be compared across firms. Assuming that all of the firms in the sample share the same risk, growth and payout characteristics after year 5, firms with low price to future earnings ratios will be considered undervalued.
An alternative approach is to estimate a target price for the negative earnings firm in five years, divide that price by earnings in that year and compare this PE ratio to the PE ratio of comparable firms today.
While this modified version of the PE ratio increases the reach of PE ratios to cover many firms that have negative earnings today, it is difficult to control for differences between the firm being valued and the comparable firms, since you are comparing firms at different points in time.
Illustration: Analyzing Amazon using Price to Future Earnings per share Amazon.com has negative earnings per share in 2000. Based upon consensus estimates, analysts expect it to lose $0.63 per share in 2001 but is expected to earn $1.50 per share in 2004. At its current price of $49 per share, this would translate into a price/future earnings per share of 32.67.
In the first approach, this multiple of earnings can be compared to the price/future earnings ratios of comparable firms. If you define comparable firms to be e-tailers, Amazon looks reasonably attractive since the average price/future earnings per share of etailers
is 65. If, on the other hand, you compared Amazon’s price to future earnings per share to the average price to future earnings per share (in 2004) of specialty retailers, the picture is bleaker. The average price to future earnings for these firms is 12, which would lead to a conclusion that Amazon is over valued. Implicit in both these comparisons is the assumption that Amazon will have similar risk, growth and cash flow characteristics as the comparable firms in five years. You could argue that Amazon will still have much higher growth potential than other specialty retailers after 2004 and that this could explain the difference in multiples. You could even use differences in expected growth after 2004 to adjust for the differences, but estimates of these growth rates are usually not made by analysts.
In the second approach, the current price to earnings ratio for specialty retailers, which is estimated to be 20.31, and the expected earnings per share of Amazon in 2004, which is estimated to be $1.50. This would yield a target price of $30.46. Discounting this price back to the present using Amazon’s cost of equity of 12.94% results in a value per share.
= Target price in five years / (1+ Cost of equity)^5
Value per share
= 30.46 / (1.1294^5)
= $16.58
At its current price of $49, this would again suggest an over valued stock. Here again, though, you are assuming that Amazon in five years will resemble a specialty retailer today in terms of risk, growth and cash flow characteristics.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Relative PE Ratios and Market Growth
Relative PE Ratios and Market Growth
As the expected growth rate on the market increases, the divergence in PE ratios increases, resulting in a bigger range for relative PE ratios.
This can be illustrated very simply, if you consider the relative PE for a company that grows at half the rate as the market.
When the market growth rate is 4%, this firm will trade at a PE that is roughly 80% of the market PE. When the market growth rate increases to 10%, the firm will trade at a PE that is 60% of the market PE.
This has consequences for analysts who use relative PE ratios. Stocks of firms whose earnings grow at a rate much lower than the market growth rate, will often look cheap on a relative PE basis when the market growth rate is high, and expensive when the market growth rate is low.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
As the expected growth rate on the market increases, the divergence in PE ratios increases, resulting in a bigger range for relative PE ratios.
This can be illustrated very simply, if you consider the relative PE for a company that grows at half the rate as the market.
When the market growth rate is 4%, this firm will trade at a PE that is roughly 80% of the market PE. When the market growth rate increases to 10%, the firm will trade at a PE that is 60% of the market PE.
This has consequences for analysts who use relative PE ratios. Stocks of firms whose earnings grow at a rate much lower than the market growth rate, will often look cheap on a relative PE basis when the market growth rate is high, and expensive when the market growth rate is low.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Relative PE Ratios
Note that the relative PE ratio is a function of all of the variables that determine the PE ratio – the expected growth rate, the risk of the firm and the payout ratio – but stated in terms relative to the market. Thus, a firm’s relative PE ratio is a function of its relative growth rate in earnings per share (Growth Ratefirm/Growth Ratemarket), its relative cost of equity (Cost of Equityfirm/Cost of Equitymarket) and its relative return on equity (ROEfirm/ROEmarket). Firms with higher relative growth, lower relative costs of equity and higher relative returns on equity should trade at higher relative PE ratios.
There are two ways in which they are used in valuation.
- One is to compare a firm’s relative PE ratio to its historical norms; Ford, for instance, may be viewed as under valued because its relative PE ratio of 0.24 today is lower than the relative PE that it has historically traded at.
- The other is to compare relative PE ratios of firms in different markets; this allows comparisons when PE ratios in different markets vary significantly.
Illustration:
Comparing Relative PE ratios for automobile stock – December 2000
In December 2000, the S&P 500 was trading at a multiple of 29.09 times earnings. At the same time, Ford, Chrysler and GM were trading at 7.05, 8.95 and 6.93 times earnings, respectively. Their relative PE ratios are reported.
Relative PE for Ford = 7.05 / 29.09 = 0.24
Relative PE for Chrysler = 8.95 / 29.09 = 0.30
Relative PE for GM = 6.93 / 29.09 = 0.24
Does this mean that GM and Ford are more under valued than Chrysler? Not necessarily, since there are differences in growth and risk across these firms. In fact, Figure 18.13 graphs the relative PE ratios of the three firms going back to the early 1990s. In 1993, GM traded at a significantly higher relative PE ratio than the other two firms. In fact, the conventional wisdom until that point in time was that GM was less risky than the other two firms because of its dominance of the auto market and should trade at a higher multiple of earnings. During the 1990s, the premium paid for GM largely disappeared and the three automobile firms traded at roughly the same relative PE ratios.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Whose Growth rate to use in PEG calculations?
Whose Growth rate?
In computing PEG ratios, we are often faced with the question of whose growth rate we will use in estimating the PEG ratios.
If the number of firms in the sample is small, you could estimate expected growth for each firm yourself.
If the number of firms increases, you will have no choice but to use analyst estimates of expected growth for the firms. Will this expose your analyses to all of the biases in these estimates? Not necessarily. If the bias is uniform – for instance, analysts over estimate growth for all of the firms in the sector – you will still be able to make comparisons of PEG ratios across firms and draw reasonable conclusions.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
In computing PEG ratios, we are often faced with the question of whose growth rate we will use in estimating the PEG ratios.
If the number of firms in the sample is small, you could estimate expected growth for each firm yourself.
If the number of firms increases, you will have no choice but to use analyst estimates of expected growth for the firms. Will this expose your analyses to all of the biases in these estimates? Not necessarily. If the bias is uniform – for instance, analysts over estimate growth for all of the firms in the sector – you will still be able to make comparisons of PEG ratios across firms and draw reasonable conclusions.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Using the PEG Ratio for Comparisons
- the risk,
- growth potential and
- the payout ratio of a firm.
In this section, you look at ways of using the PEG ratio and examine some of the problems in comparing PEG ratios across firms.
Direct Comparisons
PEG Ratios and Retention Ratios
Most analysts who use PEG ratios compute them for firms within a business (or comparable firm group) and compare these ratios.
Firms with lower PEG ratios are usually viewed as undervalued, even if growth rates are different across the firms being compared.
This approach is based upon the incorrect perception that PEG ratios control for differences in growth. In fact, direct comparisons of PEG ratios work only if firms are similar in terms of growth potential, risk and payout ratios (or returns on equity). If this were the case, however, you could just as easily compare PE ratios across firms.
When PEG ratios are compared across firms with different risk, growth and payout characteristics and judgments are made about valuations based on this comparison, you will tend to find that:
· Lower growth firms will have higher PEG ratios and look more over valued than higher growth firms, because PEG ratios tend to decrease as the growth rate decreases, at least initially.
· Higher risk firms will have lower PEG ratios and look more under valued than higher risk firms, because PEG ratios tend to decrease as a firm’s risk increases.
· Firms with lower returns on equity (or lower payout ratios) will have lower PEG ratios and look more under valued than firms with higher returns on equity and higher payout ratios.
In short, firms that look under valued based upon direct comparison of the PEG ratios may in fact be firms with higher risk, higher growth or lower returns on equity that are, in fact, correctly valued.
Controlled Comparisons
When comparing PEG ratios across firms, then, it is important that you control for differences in risk, growth and payout ratios when making the comparison. While you can attempt to do this subjectively, the complicated relationship between PEG ratios and these fundamentals can pose a challenge. A far more promising route is to use the regression approach suggested for PE ratios and to relate the PEG ratios of the firms being compared to measures of risk, growth potential and the payout ratio.
As with the PE ratio, the comparable firms in this analysis can be defined narrowly (as other firms in the same business), more expansively as firms in the same sector or as all firms in the market. In running these regressions, all the caveats that were presented for the PE regression continue to apply. The independent variables continue to be correlated with each other and the relationship is both unstable and likely to be nonlinear.
A scatter plot of PEG ratios against growth rates, for all U.S. stocks in July 2000, indicates the degree of non-linearity.
In running the regression, especially when the sample contains firms with very different levels of growth, you should transform the growth rate to make the relationship more linear. A scatter plot of PEG ratios against the natural log of the expected growth rate, for
instance, yields a much more linear relationship.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Using PEG ratio: Not all growth is created equal.
As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.
Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.
As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business. The PEG ratio is a function of:
As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business. The PEG ratio is a function of:
- the risk,
- growth potential and
- the payout ratio of a firm.
The PEG Ratio
The PEG Ratio
Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. In its more general form, the ratio of PE ratio to growth is used as a measure of relative value, with a lower value believed to indicate that a firm is under valued.
For many analysts, especially those tracking firms in high-growth sectors, these approaches offer the promise of a way of controlling for differences in growth across firms, while preserving the inherent simplicity of a multiple.
Definition of the PEG Ratio
The PEG ratio is defined to be the price earnings ratio divided by the expected growth rate in earnings per share:
PEG ratio = PE ratio /Expected Growth Rate
For instance, a firm with a PE ratio of 20 and a growth rate of 10% is estimated to have a PEG ratio of 2.
Consistency requires the growth rate used in this estimate be the growth rate in earnings per share, rather than operating income, because this is an equity multiple.
Given the many definitions of the PE ratio, which one should you use to estimate the PEG ratio? The answer depends upon the base on which the expected growth rate is computed. If the expected growth rate in earnings per share is based upon earnings in the most recent year (current earnings), the PE ratio that should be used is the current PE ratio. If it based upon trailing earnings, the PE ratio used should be the trailing PE ratio.
The forward PE ratio should never be used in this computation, since it may result in a double counting of growth. To see why, assume that you have a firm with a current price of $30 and current earnings per share of $1.50. The firm is expected to double its earnings per share over the next year (forward earnings per share will be $3.00) and then have earnings growth of 5% a year for the following four years. An analyst estimating growth in earnings per share for this firm, with the current earnings per share as a base, will estimate a growth rate of 19.44%.
A consistent estimate of the PEG ratio would require using a current PE and the expected growth rate over the next 5 years.
Building upon the theme of uniformity, the PEG ratio should be estimated using the same growth estimates for all firms in the sample. You should not, for instance, use 5-year growth rates for some firms and 1-year growth rates for others. One way of ensuring uniformity is to use the same source for earnings growth estimates for all the firms in the group.
For instance, both I/B/E/S and Zacks provide consensus estimates from analysts of earnings per share growth over the next 5 years for most U.S. firms.
As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.
Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. In its more general form, the ratio of PE ratio to growth is used as a measure of relative value, with a lower value believed to indicate that a firm is under valued.
For many analysts, especially those tracking firms in high-growth sectors, these approaches offer the promise of a way of controlling for differences in growth across firms, while preserving the inherent simplicity of a multiple.
Definition of the PEG Ratio
The PEG ratio is defined to be the price earnings ratio divided by the expected growth rate in earnings per share:
PEG ratio = PE ratio /Expected Growth Rate
For instance, a firm with a PE ratio of 20 and a growth rate of 10% is estimated to have a PEG ratio of 2.
Consistency requires the growth rate used in this estimate be the growth rate in earnings per share, rather than operating income, because this is an equity multiple.
Given the many definitions of the PE ratio, which one should you use to estimate the PEG ratio? The answer depends upon the base on which the expected growth rate is computed. If the expected growth rate in earnings per share is based upon earnings in the most recent year (current earnings), the PE ratio that should be used is the current PE ratio. If it based upon trailing earnings, the PE ratio used should be the trailing PE ratio.
The forward PE ratio should never be used in this computation, since it may result in a double counting of growth. To see why, assume that you have a firm with a current price of $30 and current earnings per share of $1.50. The firm is expected to double its earnings per share over the next year (forward earnings per share will be $3.00) and then have earnings growth of 5% a year for the following four years. An analyst estimating growth in earnings per share for this firm, with the current earnings per share as a base, will estimate a growth rate of 19.44%.
A consistent estimate of the PEG ratio would require using a current PE and the expected growth rate over the next 5 years.
Building upon the theme of uniformity, the PEG ratio should be estimated using the same growth estimates for all firms in the sample. You should not, for instance, use 5-year growth rates for some firms and 1-year growth rates for others. One way of ensuring uniformity is to use the same source for earnings growth estimates for all the firms in the group.
For instance, both I/B/E/S and Zacks provide consensus estimates from analysts of earnings per share growth over the next 5 years for most U.S. firms.
As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.
Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Normalizing Earnings for PE ratios
Normalizing Earnings for PE ratios
The dependence of PE ratios on current earnings makes them particularly vulnerable to the year-to-year swings that often characterize reported earnings.
In making comparisons, therefore, it may make much more sense to use normalized earnings.
The process used to normalize earnings varies widely but the most common approach is a simple averaging of earnings across time.
For a cyclical firm, for instance, you would average the earnings per share across a cycle. In doing so, you should adjust for inflation.
If you do decide to normalize earnings for the firm you are valuing, consistency demands that you normalize it for the comparable firms in the sample as well.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
The dependence of PE ratios on current earnings makes them particularly vulnerable to the year-to-year swings that often characterize reported earnings.
In making comparisons, therefore, it may make much more sense to use normalized earnings.
The process used to normalize earnings varies widely but the most common approach is a simple averaging of earnings across time.
For a cyclical firm, for instance, you would average the earnings per share across a cycle. In doing so, you should adjust for inflation.
If you do decide to normalize earnings for the firm you are valuing, consistency demands that you normalize it for the comparable firms in the sample as well.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Comparing PE Ratios across firms in a sector
Comparing PE Ratios across firms in a sector
The most common approach to estimating the PE ratio for a firm is to choose a group of comparable firms, to calculate the average PE ratio for this group and to subjectively adjust this average for differences between the firm being valued and the comparable firms. There are several problems with this approach.
First, the definition of a comparable' firm is essentially a subjective one. The use of other firms in the industry as the control group is often not the solution because firms within the same industry can have very different business mixes and risk and growth profiles. There is also plenty of potential for bias. One clear example of this is in takeovers, where a high PE ratio for the target firm is justified, using the price-earnings ratios of a control group of other firms that have been taken over. This group is designed to give an upward biased estimate of the PE ratio and other multiples.
Second, even when a legitimate group of comparable firms can be constructed, differences will continue to persist in fundamentals between the firm being valued and this group. It is very difficult to subjectively adjust for differences across firms. Thus, knowing that a firm has much higher growth potential than other firms in the comparable firm list would lead you to estimate a higher PE ratio for that firm, but how much higher is an open question.
The alternative to subjective adjustments is to control explicitly for the one or two variables that you believe account for the bulk of the differences in PE ratios across companies in the sector in a regression. The regression equation can then be used to estimate predicted PE ratios for each firm in the sector and these predicted values can be compared to the actual PE ratios to make judgments on whether stocks are under or over priced.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
The most common approach to estimating the PE ratio for a firm is to choose a group of comparable firms, to calculate the average PE ratio for this group and to subjectively adjust this average for differences between the firm being valued and the comparable firms. There are several problems with this approach.
First, the definition of a comparable' firm is essentially a subjective one. The use of other firms in the industry as the control group is often not the solution because firms within the same industry can have very different business mixes and risk and growth profiles. There is also plenty of potential for bias. One clear example of this is in takeovers, where a high PE ratio for the target firm is justified, using the price-earnings ratios of a control group of other firms that have been taken over. This group is designed to give an upward biased estimate of the PE ratio and other multiples.
Second, even when a legitimate group of comparable firms can be constructed, differences will continue to persist in fundamentals between the firm being valued and this group. It is very difficult to subjectively adjust for differences across firms. Thus, knowing that a firm has much higher growth potential than other firms in the comparable firm list would lead you to estimate a higher PE ratio for that firm, but how much higher is an open question.
The alternative to subjective adjustments is to control explicitly for the one or two variables that you believe account for the bulk of the differences in PE ratios across companies in the sector in a regression. The regression equation can then be used to estimate predicted PE ratios for each firm in the sector and these predicted values can be compared to the actual PE ratios to make judgments on whether stocks are under or over priced.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Comparing PE ratios across Countries
Comparing PE ratios across Countries
Comparisons are often made between price-earnings ratios in different countries with the intention of finding undervalued and overvalued markets. Markets with lower PE ratios are viewed as under valued and those with higher PE ratios are considered over valued.
Given the wide differences that exist between countries on fundamentals, it is clearly misleading to draw these conclusions. For instance, you would expect to see the following, other things remaining equal:
· Countries with higher real interest rates should have lower PE ratios than countries with lower real interest rates.
· Countries with higher expected real growth should have higher PE ratios than countries with lower real growth.
· Countries that are viewed as riskier (and thus command higher risk premiums) should have lower PE ratios than safer countries
· Countries where companies are more efficient in their investments (and earn a higher return on these investments) should trade at higher PE ratios.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Comparisons are often made between price-earnings ratios in different countries with the intention of finding undervalued and overvalued markets. Markets with lower PE ratios are viewed as under valued and those with higher PE ratios are considered over valued.
Given the wide differences that exist between countries on fundamentals, it is clearly misleading to draw these conclusions. For instance, you would expect to see the following, other things remaining equal:
· Countries with higher real interest rates should have lower PE ratios than countries with lower real interest rates.
· Countries with higher expected real growth should have higher PE ratios than countries with lower real growth.
· Countries that are viewed as riskier (and thus command higher risk premiums) should have lower PE ratios than safer countries
· Countries where companies are more efficient in their investments (and earn a higher return on these investments) should trade at higher PE ratios.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
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