15. Market-Based Valuation and Multiples

 
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Overview

Market-based valuation uses comparable metrics called multiples to value assets. In this lesson, I'll give some examples of asset multiples and how they affected by future growth.

Lesson Notes

Market-based valuation

- Value is a function of the selling price of a similar asset.
- It’s much easier to calculate that income-based valuation.
- But its ease-of-use hides a lot of limitations.

Comparable metrics or multiples

- Used to value an asset against similar assets in the market.
- Typically a ratio between sale price and income from the asset.
- Will ultimately depend on the underlying asset in question.

Finding and analysing market multiples

- Finding multiples for assets is normally quite easy, just go online!
- The size of a typical P/E multiple is ultimately driven by growth rate.
- The higher the growth rate, the higher the multiple.

Transcript

In this lesson we’re finally going to take leave of income based valuation and move on to market based valuation.

In market based valuation, value is a function of the selling price of a similar asset.

It’s much easier to calculate than income based valuation, but its ease of use hides a lot of limitations.

Market based valuation is based on comparable metrics that we use to value our own asset against similar assets in the market.

These comparable metrics are often called multiples.

Examples of multiples for when you want to buy a property include the sale price divided by annual rent, sale price divided by square foot area, or net operating income divided by the sale price.

Multiples for when you want to buy a company include enterprise value divided by EBITDA, sale price divided by EBIT, sale price all over annual sales, and the price to book ratio.

As you’ve probably noticed, most of these multiples connect the sale price of the asset to the cash flow generated by the asset.

However, the multiples you use will depend entirely on the asset in question.

Because multiples are so easy to calculate, they can be found everywhere.

To find multiples on houses in central London for example, a quick Google search yielded the following gross rental yield for each month since 2005.

If you want to find multiples on companies, it’s as easy as going to a website such as Google Finance and searching for the multiples that you want.

Here I've searched for the Google stock price, and Google Finance shows me the price-earning ratio, price to book ratio, and price to sales ratio for Google and similar companies.

To understand how these multiples work, let's now take a subset of technology companies and try to understand what their various multiples imply.

I've taken a set of familiar companies, including Apple, Microsoft, Google and Facebook, and first plotted their price earnings ratio on this page.

As you can see, huge variations in the price earnings ratio exist for these companies.

The highest PE ratio is for Netflix with a value of the company’s shares equal to 220 times its net profit.

The lowest on the other hand is Apple, with the value of the company equal to 13 times previous net profit.

So what's driving these PE ratios and why do these huge discrepancies exist? In a word, growth.

If a company has a very high priced earnings ratio, this means that the market is expecting huge growth in the future for that company.

In our current example, the market is expecting Facebook and Netflix earnings to grow much faster than Apple or Google's in the future.

Hence, the higher multiple.

Why are Facebook and Netflix expected to grow faster? Well for one, they’re much smaller companies than Apple or Google.

So it’s a lot easier for them to grow their earnings from the current level.

Outside of this fact, it’s probably to do with the company’s business model and the market may see some untapped potential for the company.

For example, in Facebook’s mobile division, advertising revenue is currently growing rapidly, much faster than an equivalent division in Apple or Microsoft.

On the right hand side, you might see that Twitter has no value for price to earnings ratio.

And that's because Twitter currently has negative earnings.

If you have a company which is often a start up with no earnings, you may want to use a different multiple such as price to sales ratio to compare to its peers.

As we can see on this chart, Twitter has a sky high price to sales ratio, compared to all the other companies on our chart.

Again, this is due to Twitter’s potential for growth.

The company has only recently begun to monetize its platform, and the market clearly sees huge potential for growth in the future.

Technology companies by their nature tend to have very high growth rates, particularly at the early stages of development.

If we looked at a more mature industry, say chemicals, we'd probably see a set of companies with much more similar multiples.

For almost all assets, not just companies, the main driver of multiples is growth.

Regardless of the asset, be it a gold mine or a seaside apartment, some price multiple will always be used by the market to value that asset.

Although multiples are easy to calculate and to find, as we’ve seen, they tend to take a very simplistic view of an asset’s value.

In the next lesson, we'll take a look at the limitations of multiples and help you understand how to profit from these limitations.