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
Thursday, 12 November 2009
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
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
Modern trading making earnings multiples obsolete
Modern trading making earnings multiples obsolete
by Grace Chen on May 19, 2008
Price to earnings multiples were once the basis of investment decisions. The analysis was simple: the return divided by the stock price should properly valuate a certain company. But with many companies all over the map in both PE and PEG ratios, investors are looking for other guidelines for evaluating an investment. Technical trading has all but taken over the short term trader, and it looks ready to conquer the long term as well.
Old value investors
Warren Buffett dominates the field of value investing. Rather than following the world’s hottest stocks, he looks for companies that are considerably undervalued, both by assets and what he believes the company is really worth. While he’s made a large fortune from his studies on value investing, the markets are seemingly turning out of his favor. Valuing a company is no longer as easy as looking for cheap assets, as many companies have little assets to back their valuations. Others trade at huge multiples of their earnings, while their competitors enjoy smaller ratios, and even others are destined to stay cheap forever due only to the nature of the business.
Case in point
It seems that many companies are selling for high premiums, even with little to back up their valuations. Take for example the internet stocks. Google sells for a PE ratio of 41 but a PEG of 1.02. While Google does sell for an extreme premium over its earnings, adjusted for growth Google is still in the buy range. Compare these statistics to the lesser rival Yahoo, which trades for a PE of 33 and a PEG of 2.8. Even prior to the failed Microsoft bid, Yahoo traded at a similar PE and PEG ratio; for the most part, it’s horribly overvalued.
Traditionally, you would think that the two valuations would come to meet each other in the middle. Google’s price would ultimately rise while Yahoo would shed a few points to come back to earth. Though this is what the rational person would think, it seems like Yahoo will forever enjoy being overpriced and Google will always be under priced. In fact, Google has never traded for a PEG ratio higher than 2. Yahoo has traded for both extremely high PE ratios and PEGs, though its data is somewhat skewed by the y2k internet bubble fiasco.
Has technical analysis beat out fundamentals?
It appears as though technical traders have finally won over the market. By looking at today’s measurements, Yahoo’s stock is kept afloat largely by technical support and resistance, while Google is much the same. The difference in trading techniques even from just 2004 to today would suggest that stocks are now traded more independently than ever. Rarely are stocks compared to reasonable value to their competitors by investors. The new age of trading is systematically making investors “one stock” types, those only willing to trade the ups and downs and day to day of a specific stock, rather than comparing it to its competition.
Investing at its roots has been crippled. The sustainability or profitability of future results are rarely calculated in many investors algorithms. Technical analysis has instead brought trading to a whole new level, where stocks are nearly as good as any other commodity. The earnings of a company no longer matter, nor do its assets, nor its valuation. The digits in the stock price are the few things that matter to most modern day traders; forget the business behind the ticker.
http://www.investortrip.com/modern-trading-making-earnings-multiples-obsolete/
Comment: Ohhhh!!!!!
by Grace Chen on May 19, 2008
Price to earnings multiples were once the basis of investment decisions. The analysis was simple: the return divided by the stock price should properly valuate a certain company. But with many companies all over the map in both PE and PEG ratios, investors are looking for other guidelines for evaluating an investment. Technical trading has all but taken over the short term trader, and it looks ready to conquer the long term as well.
Old value investors
Warren Buffett dominates the field of value investing. Rather than following the world’s hottest stocks, he looks for companies that are considerably undervalued, both by assets and what he believes the company is really worth. While he’s made a large fortune from his studies on value investing, the markets are seemingly turning out of his favor. Valuing a company is no longer as easy as looking for cheap assets, as many companies have little assets to back their valuations. Others trade at huge multiples of their earnings, while their competitors enjoy smaller ratios, and even others are destined to stay cheap forever due only to the nature of the business.
Case in point
It seems that many companies are selling for high premiums, even with little to back up their valuations. Take for example the internet stocks. Google sells for a PE ratio of 41 but a PEG of 1.02. While Google does sell for an extreme premium over its earnings, adjusted for growth Google is still in the buy range. Compare these statistics to the lesser rival Yahoo, which trades for a PE of 33 and a PEG of 2.8. Even prior to the failed Microsoft bid, Yahoo traded at a similar PE and PEG ratio; for the most part, it’s horribly overvalued.
Traditionally, you would think that the two valuations would come to meet each other in the middle. Google’s price would ultimately rise while Yahoo would shed a few points to come back to earth. Though this is what the rational person would think, it seems like Yahoo will forever enjoy being overpriced and Google will always be under priced. In fact, Google has never traded for a PEG ratio higher than 2. Yahoo has traded for both extremely high PE ratios and PEGs, though its data is somewhat skewed by the y2k internet bubble fiasco.
Has technical analysis beat out fundamentals?
It appears as though technical traders have finally won over the market. By looking at today’s measurements, Yahoo’s stock is kept afloat largely by technical support and resistance, while Google is much the same. The difference in trading techniques even from just 2004 to today would suggest that stocks are now traded more independently than ever. Rarely are stocks compared to reasonable value to their competitors by investors. The new age of trading is systematically making investors “one stock” types, those only willing to trade the ups and downs and day to day of a specific stock, rather than comparing it to its competition.
Investing at its roots has been crippled. The sustainability or profitability of future results are rarely calculated in many investors algorithms. Technical analysis has instead brought trading to a whole new level, where stocks are nearly as good as any other commodity. The earnings of a company no longer matter, nor do its assets, nor its valuation. The digits in the stock price are the few things that matter to most modern day traders; forget the business behind the ticker.
http://www.investortrip.com/modern-trading-making-earnings-multiples-obsolete/
Comment: Ohhhh!!!!!
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
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
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
Comparing a Market’s PE ratio across time
Comparing a Market’s PE ratio across time
Analysts and market strategists often compare the PE ratio of a market to its historical average to make judgments about whether the market is under or over valued.
Thus, a market which is trading at a PE ratio which is much higher than its historical norms is often considered to be over valued, whereas one that is trading at a ratio lower is considered under valued.
While reversion to historic norms remains a very strong force in financial markets, we should be cautious about drawing too strong a conclusion from such comparisons. As the fundamentals (interest rates, risk premiums, expected growth and payout) change over
time, the PE ratio will also change. Other things remaining equal, for instance, we would expect the following.
· An increase in interest rates should result in a higher cost of equity for the market and a lower PE ratio.
· A greater willingness to take risk on the part of investors will result in a lower risk premium for equity and a higher PE ratio across all stocks.
· An increase in expected growth in earnings across firms will result in a higher PE ratio for the market.
· An increase in the return on equity at firms will result in a higher payout ratio for any given growth rate (g = (1- Payout ratio)ROE) and a higher PE ratio for all firms.
In other words, it is difficult to draw conclusions about PE ratios without looking at these fundamentals. A more appropriate comparison is therefore not between PE ratios across time, but between the actual PE ratio and the predicted PE ratio based upon fundamentals
existing at that time.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Analysts and market strategists often compare the PE ratio of a market to its historical average to make judgments about whether the market is under or over valued.
Thus, a market which is trading at a PE ratio which is much higher than its historical norms is often considered to be over valued, whereas one that is trading at a ratio lower is considered under valued.
While reversion to historic norms remains a very strong force in financial markets, we should be cautious about drawing too strong a conclusion from such comparisons. As the fundamentals (interest rates, risk premiums, expected growth and payout) change over
time, the PE ratio will also change. Other things remaining equal, for instance, we would expect the following.
· An increase in interest rates should result in a higher cost of equity for the market and a lower PE ratio.
· A greater willingness to take risk on the part of investors will result in a lower risk premium for equity and a higher PE ratio across all stocks.
· An increase in expected growth in earnings across firms will result in a higher PE ratio for the market.
· An increase in the return on equity at firms will result in a higher payout ratio for any given growth rate (g = (1- Payout ratio)ROE) and a higher PE ratio for all firms.
In other words, it is difficult to draw conclusions about PE ratios without looking at these fundamentals. A more appropriate comparison is therefore not between PE ratios across time, but between the actual PE ratio and the predicted PE ratio based upon fundamentals
existing at that time.
http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf
Wednesday, 11 November 2009
Brain drain and middle-income trap key issues
Brain drain and middle-income trap key issues
Tags: Attracting talent | Datuk Johan Raslan | Datuk Justin Leong | Datuk R Karunakaran | Dr Soh Chee Seng | GDP | Genting Group Malaysia | HSBC Bank Bhd | ISIS | Jon Addis | Malaysia | MICPA | Steven CM Wong | Talented people
Written by Loong Tse Min
Wednesday, 11 November 2009 11:39
KUALA LUMPUR: Malaysia needs to reach out to talented people wherever they come from, apart from bringing back its own, said Malaysian Institute of Certified Public Accountants (MICPA) vice-president Datuk Johan Raslan.
He said many Malaysians could be found working overseas as they were often adaptable, multi-lingual and inexpensive.
“The world wants Malaysians. We need to get them back, but we must not hold them back,” Johan said in the opening address of the two-day MICPA-Bursa Malaysia Business Forum 2009.
Cities such as Hong Kong, Singapore, London and Sydney were open to attracting talent and Malaysia needed to be equally so, he said.
“We should not shut out people with skills and expertise simply because they were not born here. We need to reach out to talented people wherever they come from,” he said.
Johan added that the country’s liberalisation measures put it “on the starting block” towards becoming a high-income economy and what was needed now were the fine details.
He also said the corporate sector must take ownership of abolishing corruption and not just consider it the responsibility of the government alone. “For every taker, there is a giver,” he said.
“In the final analysis, it is equally important to provide a conducive environment that is clean, fair and predictable, to attract companies to set up here, stay here and do business.”
Speaking in the first discussion session on Competing in the New Global Landscape, Institute of Strategic and International Studies (ISIS) Malaysia assistant director general Steven CM Wong, suggested that to become a high-value economy, the country should “get off protective industries”, “get rid of energy subsidies” and “get off the dependence on foreign workers”.
He said the potential disruption to business of some of his proposals such as the last one was really part of “transition costs”. Wong, whose research interests include international economics and international relations, also suggested that the Malaysian economy was too much consumption driven and there was a need to focus on production aspects.
Datuk R Karunakaran, a former director-general of the Malaysian Industrial Development Authority, who was moderating, pointed out that one key issue to higher salary was higher productivity. “With productivity comes better pay and better income,” he said.
In terms of composition of the economy for most developed countries, more than 60% of annual gross domestic product (GDP) came from the services sector, with Malaysia somewhere just over 50%. “That is a characteristic of a high-income economy and that is the transformation we will have to go through,” he said.
Deputy director in the Public-Private Partnership Centre and Secretariat to the Economic Council of the Economic Planning Unit Dr Soh Chee Seng said: “Our productivity levels are not really low, it is just that they are falling behind other rapidly developing countries like China, India, Indonesia and Thailand.”
He agreed that it was necessary for the country to be more open to attract the talent in the areas that it needed, “not just foreign talent but also Malaysians who are attracted elsewhere”.
HSBC Bank Bhd executive director Jon Addis said the diaspora of Malaysians was not a bad thing, as his home country Britain had benefited from a similar trend.
“If those skills and money return to Malaysia, that’s a good thing.”
He questioned whether foreign workers should be an issue and suggested that it might be a better strategy to raise the standard of education for Malaysians so that they could do the higher-value jobs while leaving the low-wage jobs to foreign labour.
He also said the country’s infrastructure was still “patchy” such as in terms of public transit, which had some idiosyncrasies.
Genting Group Malaysia’s head of strategic investments and corporate affairs Datuk Justin Leong said the Malaysian culture of adaptability and flexibility provided a good talent pool for businesses to expand overseas.
He said that from his experience, most Malaysians working overseas still held Malaysian passports and continued to have a lot of goodwill towards the country. Attracting them back was a possibility through sufficiently attractive job opportunities as well as improved safety and rule of law, he said.
This article appeared in The Edge Financial Daily, November 11, 2009.
Tags: Attracting talent | Datuk Johan Raslan | Datuk Justin Leong | Datuk R Karunakaran | Dr Soh Chee Seng | GDP | Genting Group Malaysia | HSBC Bank Bhd | ISIS | Jon Addis | Malaysia | MICPA | Steven CM Wong | Talented people
Written by Loong Tse Min
Wednesday, 11 November 2009 11:39
KUALA LUMPUR: Malaysia needs to reach out to talented people wherever they come from, apart from bringing back its own, said Malaysian Institute of Certified Public Accountants (MICPA) vice-president Datuk Johan Raslan.
He said many Malaysians could be found working overseas as they were often adaptable, multi-lingual and inexpensive.
“The world wants Malaysians. We need to get them back, but we must not hold them back,” Johan said in the opening address of the two-day MICPA-Bursa Malaysia Business Forum 2009.
Cities such as Hong Kong, Singapore, London and Sydney were open to attracting talent and Malaysia needed to be equally so, he said.
“We should not shut out people with skills and expertise simply because they were not born here. We need to reach out to talented people wherever they come from,” he said.
Johan added that the country’s liberalisation measures put it “on the starting block” towards becoming a high-income economy and what was needed now were the fine details.
He also said the corporate sector must take ownership of abolishing corruption and not just consider it the responsibility of the government alone. “For every taker, there is a giver,” he said.
“In the final analysis, it is equally important to provide a conducive environment that is clean, fair and predictable, to attract companies to set up here, stay here and do business.”
Speaking in the first discussion session on Competing in the New Global Landscape, Institute of Strategic and International Studies (ISIS) Malaysia assistant director general Steven CM Wong, suggested that to become a high-value economy, the country should “get off protective industries”, “get rid of energy subsidies” and “get off the dependence on foreign workers”.
He said the potential disruption to business of some of his proposals such as the last one was really part of “transition costs”. Wong, whose research interests include international economics and international relations, also suggested that the Malaysian economy was too much consumption driven and there was a need to focus on production aspects.
Datuk R Karunakaran, a former director-general of the Malaysian Industrial Development Authority, who was moderating, pointed out that one key issue to higher salary was higher productivity. “With productivity comes better pay and better income,” he said.
In terms of composition of the economy for most developed countries, more than 60% of annual gross domestic product (GDP) came from the services sector, with Malaysia somewhere just over 50%. “That is a characteristic of a high-income economy and that is the transformation we will have to go through,” he said.
Deputy director in the Public-Private Partnership Centre and Secretariat to the Economic Council of the Economic Planning Unit Dr Soh Chee Seng said: “Our productivity levels are not really low, it is just that they are falling behind other rapidly developing countries like China, India, Indonesia and Thailand.”
He agreed that it was necessary for the country to be more open to attract the talent in the areas that it needed, “not just foreign talent but also Malaysians who are attracted elsewhere”.
HSBC Bank Bhd executive director Jon Addis said the diaspora of Malaysians was not a bad thing, as his home country Britain had benefited from a similar trend.
“If those skills and money return to Malaysia, that’s a good thing.”
He questioned whether foreign workers should be an issue and suggested that it might be a better strategy to raise the standard of education for Malaysians so that they could do the higher-value jobs while leaving the low-wage jobs to foreign labour.
He also said the country’s infrastructure was still “patchy” such as in terms of public transit, which had some idiosyncrasies.
Genting Group Malaysia’s head of strategic investments and corporate affairs Datuk Justin Leong said the Malaysian culture of adaptability and flexibility provided a good talent pool for businesses to expand overseas.
He said that from his experience, most Malaysians working overseas still held Malaysian passports and continued to have a lot of goodwill towards the country. Attracting them back was a possibility through sufficiently attractive job opportunities as well as improved safety and rule of law, he said.
This article appeared in The Edge Financial Daily, November 11, 2009.
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