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17. More Tips on Using Multiples
In this lesson, I include 4 additional tips when using multiples to value assets. These will help you avoid some common mistakes that catch many investors.
More tips on using multiples
- These tips won't overcome the limitations in the previous lesson
- However, they will help you avoid common mistakes made with multiples valuation
1. Ensure your comparable assets are relevant
- Companies in the same industry often have different business models and growth prospects
- Many large companies are also diversified into lots of different markets
-Well known examples include Amazon, Berkshire Hathaway and GE
- For these companies, it's easier to value each part of the business separately
2. Use forward-looking estimates
- Numerous studies have show this leads to more accurate valuations
- Senior management and company analysts will provide these estimates for you
- Estimates are often very close to the actual numbers
3. Do not include loan repayments in the multiple
- Interest payments (specific to the current owner) can distort the net profit
- It's better to use an income metric (e.g. EBIT) which does not have interest payments subtracted
- This way, the performance of the business can be compared effectively with comparables
4. Exclude one-off revenues and costs
- One-off items can substantially affect earnings for a single year
- This can cause investors to undervalue / overvalue a company
- Always remove one-off revenues and costs before calculating your multiples
This lesson covers some additional tips when using multiples to value assets.
While this won't remove the limitations of multiples I described in the previous lesson, they will make your multiples analysis more accurate.
The first tip is to make sure your comparable assets are relevant.
When investing in isolated assets, such as wind farms and property, this is quite easy to do.
However, when investing in companies, this can be a lot harder, because many companies are diversified into numerous markets, have different business models, and have different competitive advantages.
In many ways, finding the right comparables is probably the hardest part of valuing companies using multiples.
Take for example Amazon.
Not only is it a retailer, but it also manufactures electronic devices such as the Kindle, it provides web services to developers through its AWS product, and now it’s even venturing into TV production.
Trying to find a comparable company to Amazon as a whole would be very difficult.
One option you should consider when trying to value diversified companies, is to split the company into various parts and then apply a different multiple to each part.
The next tip is to use forward looking estimates rather than historical figures.
Numerous studies have shown that multiples based on forward looking earnings provide more accurate valuations than those on historical earnings.
To find out forward looking earnings for public companies, stock analysts and company management will often give guidance on the expected earnings for the next financial period.
While these are not always absolutely accurate, they’re often close to the actual numbers when these are eventually released.
My next tip is to remove the interest and loan repayments from your multiples.
Investors will have different loan terms when buying an asset, depending on the asset in question, and the investor’s credit worthiness.
Let's say that we have an airline that generates $20,000,000 in EBIT every year.
The owners of this company took out a huge loan to buy the company, and as a result, the interest payment is very high, and gobbles up $15,000,000 of the EBIT, leaving the company after tax with a very small net profit.
Now consider an identical airline with the exact same EBIT, with no debt.
Here the net profit is $13,000,000.
To convert these companies properly, we are better off using EBIT than net profit, which is distorted by the loan repayments specific to the current owner.
Always try to use an earnings figure, before interest and tax are paid, to avoid this distortion.
Our final tip is to exclude the one off revenues and costs of an asset before comparing multiples.
Let's say you want to buy a property that needs to undergo substantial maintenance this year.
This maintenance has been postponed for the last couple of years and will cost $300,000.
The rental income on the property is currently $1,000,000 and the annual costs are typically $100,000.
This year, the profit before interest and tax will be $600,000, but in future years it’s expected to go back up to $900,000 after the one-off maintenance has been paid.
Obviously when you are valuing this asset using multiples, the one-off maintenance cost should be excluded, and the asset should be valued on the profit before interest and tax, excluding this amount.
Otherwise you are at risk of undervaluing the asset considerably based on a one-off cost.
These tips will serve to improve your multiples analysis significantly.
However, they won't address the limitations that I highlighted in earlier lessons.
In our next and final lesson, we'll wrap up our intro to valuation with a quick overview of cost based valuation.