This lesson was prompted by a question that came in from a reader and student of our courses the other day: "When you divide Enterprise Value by Revenue (EV / Revenue), or Price Per Share by Earnings Per Share (P / E), what does that actually mean?
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
In other words, if Enterprise Value / Revenue is 5.8x, what does that number actually mean?"
Answer often given in textbooks: How valuable a company is in relation to its sales, profits, and so on... based on those metrics, how does the market value that company?
But the real answer: the multiple itself means nothing at all!
By itself, a single valuation multiple such as 5.8x or 15.3x or 25.7x means... absolutely nothing.
Valuation multiples are ONLY meaningful in relation to the multiples of OTHER, similar companies ("public comps" or "public company comparables").
It's like saying, in real life, "The asking price for that house is $500,000, or around $500 per square foot. What does that mean?"
Answer: It depends... on the asking prices of similar houses in the region, also on the location, the type of house, # beds and bathrooms, the condition, the neighborhood, the public school system...
Could mean that the house is very expensive, or that it's very cheap, or that it's priced about right.
You already know this if you've studied valuation and have valued companies on your own...
BUT there are 2 specific points that often go overlooked with valuation multiples:
1. The companies you're comparing should ideally have similar growth and margin profiles, or the comparison is less meaningful.
It's NOT enough just to be in the same industry and be about the same size - that's a starting point, but financial profiles should ideally be similar as well.
Be very careful - acquisitions often distort these numbers!
Very different margins also distort the numbers (ex: 2 companies with similar revenue and 1 has a much higher margin - mathematically speaking, very likely to trade at a LOWER multiple just because the denominator will be bigger).
2. Even if the companies DO have similar financial profiles, a higher or lower multiple doesn't necessarily mean that one company is "overvalued" or "undervalued" because qualitative factors also play a role.
For example, did the company just make an acquisition? Did it miss earnings? Did it get sued? Did a new competitor pop up?
Think of valuation multiples as "clues" in a detective story... they can guide you in the right direction, but 1 clue is not enough evidence to solve the mystery of whether a company is valued appropriately.
We demonstrate both of these points with Ralcorp (a food and beverages company) in the video, and show you how the set of public comps all have very different financial profiles that were impacted by acquisitions in some cases.
1. A valuation multiple means nothing on its own - only meaningful when compared to other companies', and ideally the median multiple from a set of other companies.
2. When picking a set of public comps, it's not just about industry and size... even if you do select companies with those criteria, must pay attention to growth and margins as well.
If all the companies in your set have very different growth and margins from the company you're valuing, you may want to consider a different set.
If there are acquisitions, it's better to pay more attention to forward multiples / growth rates / margins instead - for 1-2 years in the future.
The analysis is MOST meaningful if, for example, all the companies have very similar growth and margins but the one you're looking at trades at much different multiples - then it's worth investigating further and seeing what explains that.
3. Just because a multiple is higher or lower than other companies' multiples doesn't mean that the company you're valuing is overvalued or undervalued... it's just one of many factors.
Here, the presence of a hostile bidder threw off the numbers. Plus, rumors of the company spinning off divisions...
Could be any number of things in real life as well - earnings announcements, changes in strategy, expansion plans, patents, lawsuits, management team changes, etc.