Abstract
This study addresses the differences between firms and the impact on valuations based on multiples. It broadly describes the need for relative valuation which is increasingly used in assessing individual business or corporations. On a theoretical level, it captures the advantages and shortcomings of multiples. It also describes why the multiples differ from one institution in one sector to another whilst addressing the factors that cause the anomalies. In addition it highlights what the value drivers are behind the multiples and the significant role they play in arriving at multiples. Alongside the paper also details how these value drivers are systematically aligned in producing results. It emphasizes largely on enterprise valuation, and the different methods used in Enterprise valuation, formulas and application. The basic conclusion is that multiples nearly always have broad dispersion, which is why valuations performed using multiples may be highly debatable. 1. Introduction
Valuation is the process of determining the current worth of an asset or a company in the financial aspect. There are many techniques that can be used to determine value, some of which might be subjective and the others objective. Judging the contributions of a company's management would be more of a subjective valuation technique, while calculating intrinsic value based on future earnings would be an objective technique. However, this paper will exclusively focus on valuation with multiples which is based on the method of relative valuation.

2. Literature review
2.1 Definition of multiple
A valuation multiple is simply an expression of market value relative to a key statistic that is assumed to relate to that value. To be useful, that statistic – hether earnings, cash flow or some other measure – must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value.

There are two basic types of multiple – enterprise value and equity:

2.1.1 Enterprise multiples express the value of an entire enterprise – the value of all claims on a business – relative to a statistic that relates to the entire enterprise, such as sales or EBIT.

2.1.2 Equity multiples, by contrast, express the value of shareholders’ claims on the assets and cash flow of the business. An equity multiple therefore expresses the value of this claim relative to a statistic that applies to shareholders only, such as earnings (the residual left after payments to creditors, minority shareholders and other non-equity claimants).

3. Using valuation multiples
3.1 Relative Valuation – Observed Multiple versus Comparable
There are several ways one can apply multiples in valuation. The common approach is to compare the current multiple to a historical multiple measured at a comparable point in the business cycle and macroeconomic environment. An alternate approach is to compare current multiples to those of other companies, a sector or a market, and compare the current spread between them to a historical spread.

3.2 Relative Valuation – Observed Multiple versus Target Multiple
However, one can also compare a stock’s current multiple to a calculated fair or target multiple. At different points in the business cycle the ‘fair’ and observed multiples are likely to differ. A simple investment strategy would be to sell when the current multiple is above the fair multiple and buy when it is below.

4. Value Drivers
Essentially value drivers are the inputs that have the greatest impact on value and these are the estimates of sustainable margins and revenue growth. To a lesser extent, assumptions about how long it will take the firm to reach a sustainable margin and reinvestment needs in stable growth have an impact on value, as well. In practical terms, the bulk of the value of these firms is derived from the terminal value. While this will creates worry for few, it mirrors how an investor makes returns in these firms. The payoff to these investors takes the form of price appreciation rather than dividends or stock buybacks. Another way of explaining the dependence on terminal value and the importance of the sustainable growth assumption is in terms of assets in place and future growth. The value of any firm can be written as the sum of the two.

Value of Firm = Value of Assets in Place + Value of Growth Potential

For start-up firms with negative earnings, almost all of the value can be attributed to the second component. Not surprisingly, the firm value is determined by assumptions about the latter

4.1 Aligning multiples and value drivers
More common way to look at multiples is to plot them relative to various value drivers. The most frequent comparisons are multiples versus growth in an underlying statistic and multiples to return on capital. in other words, multiples are commonly plotted relative to growth or return on capital.

4.1.1 Multiple to growth
This includes such comparisons as PE ratio to earnings growth (the PEG ratio), EV/EBITDA to EBITDA growth and so forth. A low multiple to growth indicates potential undervaluation.

But not all growth adds value, is to be noted; this type of comparison ignores profitability, which determines whether growth adds or subtracts value. One should at the least consider long-term growth potential, the sustainability of short-term growth and cash flow reinvestment required to generate growth. Therefore care must be used in comparing multiples to growth rates, as not all growth adds value.
Chart 1: Multiple to Growth Caveat: This type of plot presumes a linear relationship between multiples and growth. But a non-linear relationship is more likely. This suggests that these relationships may not be statistically significant and one may not be able to confidently ‘eyeball’ stock values relative to the regression line. The actual relationship will depend on other factors such as return on capital. One should be careful not to apply a simple multiple-to-growth relationship or risk overvaluing high-growth stocks and undervaluing low-growth stocks. This is particularly true of low-growth companies – note that zero-growth companies will not trade at a zero multiple.

4.1.2 Multiple to return on capital
This includes such comparisons as P/BV compared to ROE, EV/invested capital compared to return on capital, or, alternatively, a comparison of the return on capital to the cost of capital. Essentially this is a decomposition of a price to earnings or EV/net operating profit multiple.

Chart 2: Multiple to return on capital 4.1.3 Asset multiple to excess return multiple
A variant of the above chart is to compare an asset-based multiple (such as enterprise value/invested capital or price/book) to return on capital or equity or to an ‘excess return multiple’.
This approach provides a clear picture of over- and undervaluation, since it directly ties the market’s valuation of an asset to the excess return earned over and above the cost of that asset, in a linear fashion. All key value drivers are shown and related to market value in a single chart.

Chart 3: Asset multiple to excess return multiple

4.1.4 Multiple to interest rate
A less common approach is to compare a yield measure with interest rates or the cost of capital. The earnings yield ratio is the most commonly used of this type of comparison. Another approach is to compare a multiple to the reciprocal of the cost of capital, eg PE:(1/cost of equity) or EV/NOPLAT:(1/WACC).

4.2 Choosing the right multiple
This is a matter of individual judgment and common sense. Multiples used should be relevant and useful and result in the least overlap. Economy of effort is also important: there is an inevitable trade-off between cost/time involved in adjusting multiples and improved comparability. It is recommended that multiples be tested for statistical significance, using at least one business cycle of time-series data.

5. Enterprise value multiples
5.1 What is Enterprise Value?
5.1.1 Enterprise value or EV is the cost of buying the right to the whole of an enterprise's core cash flow
5.1.2 It is equal to the estimated value of the operations of an enterprise as represented by the value of the various claims on cash flow and profit
5.1.3 EV equals market capitalization plus seasonally adjusted net debt, pension provisions, the value of minorities and other provisions deemed debt

Chart 4: Enterprise Value Components Enterprise value comes in three flavors: total, operating and core EV, as described below.
Type Description
Total The value of all the activities of the business. Includes the value of investments and associates, and non-core assets
Less Estimated market value of non-operating assets (investment and usually associates)
= Operating The value of all operating activities. Total enterprise value less non-operating assets at market value
Less Non-core assets (non-operating assets and operating assets not a core activity of the business)
= Core Total enterprise value less the value of non-core assets – those operations not regarded as part of core activities and which are desirable to exclude from the calculation of valuation multiples
• Non-core assets include non-operating assets but may also include other trading operations which are very different in nature to the core activities of the enterprise
• The exclusion of non-core assets makes the calculation of enterprise value more subjective (in most cases there is no market-determined value for the non-core assets) but it does result in more meaningful and comparable valuation multiples

Chart 5: Enterprise Value Typology

5.2 Multiples Option
Earnings multiples remain the most commonly used measures of relative value.
5.2.1 Earnings Multiple
5.2.1.1 In earnings multiples, the asset values are expressed in terms of their earnings. In other words, the value would be a multiple of earnings that the asset generates
5.2.1.2 In the case of shares, the price is expressed using Earnings Per Share(EPS)
5.2.1.3 The value of a company would be in multiples of its operating revenues (i.e., EBIT or operating income).
5.2.1.4 Valuation in the global context usually considers EBDITA (Earnings before depreciation, interest, taxes and amortization) instead of EBIT. Reasons to this is to consider the real cash flow generation of the business and also to exclude the impact of different methods of depreciation
However it is important to note that the earnings multiples are impacted by the growth potential and risk

5.2.2 Book value (BV) multiples
In the case of BV Multiples, the value of an asset is based on accounting information or book values. Book value is a function of the initial cost and subsequent adjustments through depreciation and impairment, wherever applicable. With respect to shares, the price of a company’s share is expressed as a multiple of the book value of the equity share. However, from company valuation perspective, the market value of a company will be related to the book value of assets.

Book Value multiples help in achieving two main objectives:
5.2.2.1 For ascertaining whether the future growth opportunities are properly reflected in the market price
5.2.2.2 For assessing whether the market price is over or under valued
It is important to note that BV multiples are also impacted by growth potential and risk. Hence, the price to book value ratio can vary widely across industries.

5.2.3 Replacement Value Multiples
In situations where the book value is considered as not an adequate measure of the true value of assets, replacement cost of the assets can be taken. Tobin uses the replacement cost for valuing businesses. The ratio used by Tobin is popularly known as “Q” Ratio.
Tobin’s Q Ratio = Market Value of the firm Replacement cost of assets

5.3 Enterprise Value Multiples Applications in Business Environment
There are many different enterprise value multiples that can be calculated, depending on the circumstances. What is most important is that the denominator represent a flow to all claimants on enterprise cash flow. Adjustments should be made to both enterprise value and the denominator where necessary (and possible) to ensure that apples are being compared with apples.

5.3.1 Enterprise Value / Sales
Definition: Core EV / sales
Formula:

Application Method:
5.3.1.1 EV/sales is a crude measure, but least susceptible to accounting differences; it is equivalent to its equity counterpart, price to sales, where a company has no debt.
5.3.1.2 EV/sales is useful when accounting differences among comparables are extreme, or where profit or cash flow figures are unrepresentative or negative. It is frequently used for unprofitable or cyclical firms where there are problems in measuring profit or cash flow further down the P&L. As a proxy for cash flow, sales has the virtue of being stable and relatively unaffected by accounting policies.
5.3.1.3 EV/sales is also useful in identifying restructuring potential. Net margin is a key driver of this measure; low profitability (low net margin) would result in a low value for a given level of sales.
5.3.1.4 Be careful that the sales figure is representative; generally EV/sales should not be used for companies with variable, periodic sales, such as property developers.

5.3.2 EV / EBITDA
Definition: Core EV / earnings before associates, interest, tax, depreciation, amortisation, non-cash changes in provisions and before reported exceptional items.
Formula:

Application Method:
5.3.2.1 EBITDA is a proxy for operating cash flow, and EV/EBITDA – probably the most popular EV multiple – is a price to cash flow multiple. Its popularity stems from the fact that it is unaffected by differences in depreciation policy and appears unaffected by differences in capital structure.
5.3.2.2 However, while EBITDA is closer to cash flow than other profit measures it is not a true cash flow, as it does not incorporate either asset depreciation or capital expenditure. Also, EBITDA is a pretax measure, whereas management can potentially add value through skilled tax management.
5.3.2.3 EV/EBITDA is affected by a firm’s level of capital intensity (measured as depreciation as a percentage of EBITDA). All things being equal, higher capital intensity results in a lower EV/EBITDA multiple.
5.3.2.4 EV/EBITDA is most useful in comparing companies with a selected peer group that has a comparable level of capital intensity; comparisons of a stock with a sector average can also be useful as long as there is not a large variation in capital intensity within the sector.
5.3.2.5 On the other hand, comparisons of a stock with the market, comparisons across sectors and comparisons of a sector with the market are unlikely to be meaningful. 5.3.2.6 In the charts below, we contrast the European retail and oil sectors. The more diverse retail sector displays a wide range of capital intensities, whereas the oil sector displays a greater degree of homogeneity, in part reflecting the truly global nature of the oil and gas business.
Chart 6: European Retail Sector Chart 7: European Oil Sector 5.3.2.7 EV/EBITDA cannot be used when current cash flow is negative. Use normalized EBITDA, or a forward multiple, instead

5.3.3 EV / EBIT
Definition: Core EV/core earnings before goodwill amortisation (but after amortisation of other intangibles), associates, interest and taxes. It is stated pre reported exceptional or extraordinary items. Alternatively, this multiple may be defined as total EV/total EBIT (instead of core EV/core EBIT).
Formula:

Application Method:
5.3.3.1 EBIT is a post-goodwill figure. However, it is believed that goodwill amortization is not an economic charge and should properly be added back to operating profit.
5.3.3.2 EBIT is a better measure of ‘free’ (post-maintenance capital spending) cash flow than EBITDA, and is more comparable where capital intensities differ.
5.3.3.3 EBIT is, however, affected by accounting policy differences for depreciation. EV/EBIT is most useful where there are relatively small differences in accounting treatment of depreciation among comparables.

5.3.3 EV / Enterprise Free Cash Flow
Definition: Core EV / normalized after-tax core enterprise free cash flow (or FCF, also known as free cash flow to the firm). ROIC is calculated using after-tax FCF in the numerator.
Formula:

Enterprise Free Cash Flow:
Enterprise free cash flow is the cash available to the providers of finance.
FCF = debt cash flow + equity cash flow. It may be used:
- To pay interest or repay debt
- To build cash balances or other investments
- To pay dividends or buy back shares
Free cash flow must be after tax and all investment expenditure needed to support the future cash flow forecast.

Application Method:
5.3.3.1 FCF is calculated using actual working capital changes, capital spending and other non-cash adjustments.
5.3.3.2 Use of historic FCF can be problematic, because fluctuations in cash flow items can cause it to be highly volatile, making EV/FCF a less useful multiple.
5.3.3.3 One underappreciated benefit of accounting is that the revenue/cost matching principle results in an allocation of costs and benefits, however imperfectly. This means that profit may be a better predictor of future cash flow than any single cash flow. Since cash flow may be more ‘lumpy’ (if, for example. company has made a substantial investment, which will depress current cash flow), the user must be careful that it is representative or otherwise ‘normal’
5.3.3.4 Cash flow is better used – in fact is essential – in a discounted cash flow valuation because multi-period cash flow is used instead of a point estimate. It is preferred the use of a smoothed cash flow figure such as OpFCF, provided the assumptions underlying the calculation are sensible.

6. Advantages/Disadvantages of Multiples
6.1 Disadvantages: There are a number of criticisms levied against multiples, but in the main these can be summarized as:

6.1.1 Simplistic: A multiple is a distillation of a great deal of information into a single number or series of numbers. By combining many value drivers into a point estimate, multiples may make it difficult to disaggregate the effect of different drivers, such as growth, on value. The danger is that this encourages simplistic – and possibly erroneous – interpretation.

6.1.2 Static: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture the dynamic and ever-evolving nature of business and competition.

6.1.3 Difficult to compare: Multiples are primarily used to make comparisons of relative value. But comparing multiples is an exacting art form, because there are so many reasons that multiples can differ, not all of which relate to true differences in value. For example, different accounting policies can result in diverging multiples for otherwise identical operating businesses.

6.2 Advantages: Despite these disadvantages, multiples have several advantages such as:

6.2.1 Usefulness: Valuation is about judgement, and multiples provide a framework for making value judgements. When used properly, multiples are robust tools that can provide useful information about relative value.

6.2.2 Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user-friendly method of assessing value. Multiples can help the user avoid the potentially misleading precision of other, more ‘precise’ approaches such as discounted cash flow valuation, which can create a false sense of comfort.

6.2.3 Relevance: Multiples focus on the key statistics that other investors use. Since investors in aggregate move markets, the most commonly used statistics and multiples will have the most impact.

6.3 Why multiples vary
There are fundamentally the following reasons why they differ:

6.3.1 Difference in the quality of the business(i.e. difference in value drivers)
All things equal, higher-quality businesses deserve higher valuation multiples. This is another way of saying that there are qualitative differences in the fundamental underlying drivers of valuation, such as quality of management, available investment opportunities, strategy and branding. These can be distilled down to four quantitative valuation drivers: return on capital, cost of capital, growth and duration of growth.

As investors, we are interested in how to allow for differences in these value drivers. How much is growth worth? What is the impact of a change in return on capital?

6.3.2 Accounting differences
Differences in accounting policies that do not affect cash flow do not affect value. But accounting policy differences do affect profit multiples and, as a result, differences in multiples can paint a misleading picture of relative valuation.

6.3.3 Fluctuations in cash flow or profit
Multiples are only meaningful if the profit statistic used is representative of the future. Profit fluctuations can have a substantial impact on multiples. A multiple is only meaningful if the profit on which it is based is indicative of future profit potential. Where this is not the case, one should: 6.3.3.1 exclude exceptional items if using historical profits; or 6.3.3.2 use forecast rather than historical profits

6.3.4 Mispricing
If differences in multiples are not fully explained by differences in business quality, accounting differences or profit fluctuations, then the stock may simply be mispriced. It is the analyst’s task to identify mispricing; the analyst’s skill is in distinguishing between differences arising from underlying fundamentals – and therefore justified – and those arising from mispricing.

4. Conclusion
By distinctly categorizing the form of an enterprise into contractual and organizational relationships, it allows for a development of Business Ethics based on the characteristics of this form. Business Ethics is neither to be viewed as positive external corrective to the negative effects of economic activities, or external factor for economic blindness, or a temporary arrangement to counter an incomplete contractual relationship. Instead it is to be viewed as a constitutive element of the form itself and integration of moral factor into the economic and organizational context corresponds to its economic and organizational relevance.
.
Appendix

Abbreviations

EBIT Earnings before Interest and taxes
ROIC/ROE incremental post-tax return on incremental total investment and equity g assumed long-term growth rate
WACC weighted average cost of capital
COE cost of equity
T effective tax rate
D depreciation and amortization as a % of EBITDA
M operating margin
OpFCF Operating free cash flow
Capex Capital expenditures
PE Price earnings
EPS Earnings per share
EV Enterprise value
EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization
IRR Internal return rate
BV Book value
PEG Price earnings to growth
NOPLAT Noral operatting profit less adjusted tax
FCF Free cash flow

Reference List

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Damodaran, A., 1999, Dealing with Cash, Marketable Securities and Cross Holdings, Working paper, www.stern.nyu.edu/~adamodar/New_Home_Page/papers.html
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