4.2 Valuation Methods

Welcome back. We’re in module four, which is valuation methods, and we’re now gonna look at the second method of company valuation. This method is called the multiple method. The multiple method is kind of midway in between the ease, simplicity of market valuation and finding market cap. And the next method that we’re gonna look at, which is really the most respected, the most used for serious purposes, for serious investment, business investing, business buying, things like that, which is the discounted cash flow. This one here, multiples, right in between. And multiples is really nice because the truth is, when we talk about the next method, you are going to see how involved it is. It really is going to take quite a bit of work. And therefore, we don’t want to get into discounted cash flows unless we really think that there is an opportunity there. So the first thing we’re gonna do is we’ll look at, we’ll get market cap, quick and easy. Then we might run some multiples and we’ll see if this business is overvaluated by the market or undervaluated by the market, okay? So, multiples method. In multiples method we’re gonna do some ratios and ratios are great because this helps us compare firms in the same industry or same sector, but even of different sizes. Cuz we’re gonna bring them down to little ratios, little multiples. The first step to do is you gotta know your sector. And it would be ridiculous to invest in a business or sector that you don’t know anything about. So you gotta know your sector. If you don’t know the sector, research. And in the researching of it, or as you get to know that sector, you’re gonna begin to know what elements of business, what metrics are most relevant. What multiples are going to be the ones that you really wanna look at in this industry, okay. So, how does the market, how do professionals tend to decide whether this company is strong or weak? And that changes from industry to industry. I was actually teaching this exact course, a finance course, just a couple months ago, and I used an example of a company. And we looked at the ROE, like we talked about in the last course, and the ROE was very good. And then we broke it down into the DuPont. And I did this on purpose to kind of startle the students. Because when we did the DuPont method, they realized that the profit margins of this company, the operating margins were extremely, extremely low. And yet they were kinda puzzled at first because they thought, wow, how could that be so low and yet the ROE be so high? And then I reminded them and said, well, look at the size of this company, and look at the name of the game of this company, right? Look at what this company is actually doing. And because of the nature of the company, it was okay that profit margins were very low. That didn’t really affect anything. What mattered is that everything else was very high, right? So, in that particular sector industry, you really wouldn’t want to judge the firms by profit margin, okay? Because remember, revenue equals price times volume, right? And their volumes are crazy through the roof right? So that’s what you gotta consider when you’re evaluating companies, is what’s gonna be important to look at in this company? That’s the backbone of multiples. So with multiples, let’s do an example, okay? We’re gonna take a company in an industry. Any industry, it doesn’t matter, because this is theoretical at this moment right. So we got a company, we’re gonna call it company A. We want to find out what is company A worth. Maybe we’re looking at buying company A, and we want to make an offer. Maybe we’re looking at selling company A. We’ve got to figure out what we want to ask. So company A just to set up a situation, we have $100 million in debt, right? So we owe $100 million. We’ve got annual sales of 180 million. We’ve got EBITDA which is earnings before interest, taxes, depreciation, and amortization. EBITDA of 70 million, and final earnings, right, so final net profit of 40 million. Now what we’re gonna do is we’re gonna look at companies in the same industry. And we’re gonna assume that they’re valued with sales, EBITDA, things like that. Now, what we’re gonna do here is we’re gonna do our research and put together the numbers and we’re gonna do this for every company that we’re evaluating. So, you don’t want to choose 10, 12 companies, you wanna choose three or four other companies. So what we’re gonna do is get their financial statements, and we’re gonna pull the relevant metrics that we want to work with, the relevant numbers. And in doing so, we’ve got a couple different options, a couple different choices we can do, okay. So to perform our multiple analysis, what we’re gonna do is we’re gonna choose four companies in the same sector. So you see up here, you see four companies. Companies 1, 2, 3 and 4. These are four companies in the same sector, the same industry, and we’ve pulled their numbers and we’re basically just gonna look at them. Market cap, sales, EBITDA, earnings, okay, so that’s their performance. That’s the numbers that we’re gonna use. Whether that’s the last 12 months, whether we think it’s six months past, six months in the future, or whether we think that’s what’s gonna be there in 12 months, okay? Those are the numbers we’re gonna use. So then what we do, is we change those into multiples. We do that by using the market cap. So we take the market cap for each company and we divide it by sales, divide it by EBITDA, divide it by earnings, okay. Doing that, we get these multiples for the four companies that we’re gonna use as a comparison, right, for the company that we want to evaluate, which we’ve called company A. So we’ve got our multiples here in the table, you see them right here. And then at the bottom, we’re simply gonna average those out. Gonna take the average sales multiple, the average EBITDA multiple, the average price-to-earnings multiple. So, 3.1, 8.1, 12.6, okay? Now, we’re gonna take those and we’re going to apply them to Company A that we want to evaluate, the company we’re interested in. So, we’re going to multiply their sales, right, by 3.1, the average multiple. We’re gonna take their EBITDA multiple, so take their EBITDA, 70 million and multiply it by 8.1. We’re gonna take the price to earning multiple which was 12.6, multiply it by their earnings, which is 40 million. So what we come up with is we come up with these values. 558 million for the sales multiple, but we have to reduce it by their debt. So, take that $100 million off, so we get 458. The EBITDA multiple gives us 565 million. Reduce it by the 100 million, so we get 465 million. The same with the price-to-earnings multiple gives us 504 million, minus our debt is 404 million. So, in the end, our calculations give us a value of $405 to $465 million, based on multiples. Now, here’s the interesting thing that you’ve just figured out, probably. The multiples does not give us an exact answer. It gives us a range. Gives us a range based on what other companies are doing, and what other companies are worth on the market. So as we go to market with this, if we’re trying to buy this company, we know that it’s worth 405 to 465. We actually probably wanna bid a bit under 405 and hopefully not pay much over 405. If we want to sell this company, we believe this company is worth $465 million. We’re probably gonna start our bidding up at 5, 550. And certainly don’t really want to get far below 465 million cuz we believe it could be worth as much as that. But that’s basically the range, and if a fair price is paid for this company, based on multiples, it will be purchased for somewhere between $405 and $465 million. So that’s the multiples method of valuation. In the next section, we’re gonna talk about the final method, which is the discounted cash flows. I’ll see you then.