CHAPTER 1



CHAPTER 16

A “THEORY” OF MULTIPLES

LEARNING OBJECTIVES

1. How and why analysts use the multiples approach to value companies.

2. What are the arguments for and against using multiples to value companies.

3. Why the multiples approach requires that firms be comparable.

4. How to identify comparable firms.

5. How earnings quality issues affect comparability in the multiples approach.

6. How the multiples approach can be an acceptable shortcut to discounted cash flow valuation.

TRUE/FALSE QUESTIONS

1. Research has shown that multiples such as the price/earnings and market/book ratios can be used to predict future stock returns, suggesting that firms with low multiples are undervalued and multiples can be used to rank investments.

(moderate, L.O. 1, Section 1, true)

2. In the multiples valuation, the forecast is summarized using many variables as in the cash flow models.

(moderate, L.O. 1, Section 1, false)

3. The analyst is comparing “apples and oranges” if the consistency requirements are not met for the multiples formula.

(easy, L.O. 1, Section 1, true)

4. When the analyst examines several firms, it is unlikely that their multiples will be identical.

(moderate, L.O. 1, Section 1, true)

5. The analyst will use different steps when using a multiple to estimate the value of a company’s equity.

(moderate, L.O. 1, Section 1, false)

6. The multiples approach requires only one explicit assumption whereas the discounted cash flow model requires several explicit assumptions.

(moderate, L.O. 1, Section 1, true)

7. Arguments for and against the use of the multiples approach can both be correct when placed in the proper context.

(difficult, L.O. 2, Section 2, true)

8. The multiples approach is less scientific because it does not involve a number of assumptions.

(moderate, L.O. 2, Section 2, false)

9. An analyst can use the multiples approach, but the analyst must understand that doing so is only valid when it is acknowledged that cash flow actually creates value and the multiples analysis is a shortcut to valuing cash flow.

(difficult, L.O. 2, Section 2, true)

10. The key step in a successful multiples valuation is using a discounted cash flow analysis of the target firm to support the multiples valuation findings.

(moderate, L.O. 3, Section 3, false)

11. Many variables differ across firms, yet, to be comparable, firms do not need to have similar values for all of these variables.

(moderate, L.O. 3, Section 3, false)

12. In looking at a list of potentially comparable firms, an analyst should check to see that the comparable firms’ capital structures are similar to that of the target firm.

(moderate, L.O. 4, Section 4, true)

13. When using a multiples approach, an analyst should always use the total earnings of a firm rather than EPS.

(moderate, L.O. 4, Section 4, false)

14. If an analyst researches thoroughly, it is quite likely that the analyst will find a perfectly comparable firm.

(easy, L.O. 5, Section 5, false)

15. One strategy used to deal with situations in which perfect comparability is not possible is to adjust the multiple for differences in important variables.

(moderate, L.O. 5, Section 5, true)

MULTIPLE CHOICE QUESTIONS

16. In the multiples approach, the analyst assumes the ratio of value to some firm-specific variable is the same across firms. The most common multiple is the:

a. earnings per share ratio

b. price/sales ratio

c. price/earnings ratio

d. market/book ratio

(moderate, L.O. 1, Section 1, c)

17. The multiples approach is based on the idea that similar assets sell at similar prices. Analysts expect that two firms in the same industry would be comparable for this purpose. The term “comparable,” when used in this sense, means that two firms would differ only in their:

a. growth prospects

b. size

c. operating margins

d. cash flow needs

(moderate, L.O. 1, Section 1, b)

18. The multiples approach is used to value one firm based on the observed multiple of another. The firm being valued is called the:

a. multiple driver

b. value driver

c. comparable firm

d. target

(easy, L.O. 1, Section 1, d)

19. For the multiples formula to work both mathematically and logically, there must be consistency between the multiple and its value driver. The element necessary for consistency is:

a. the multiple and value driver must be for the same period or as of the same date

b. the value driver and numerator of the multiple must be based on exactly the same definition

c. the value driver and denominator of the multiple must be based on exactly the same definition

d. Answers a and c are both correct.

(moderate, L.O. 1, Section 1, d)

20. In the multiples formula, the numerator is:

a. VCOMP

b. VTARGET

c. XCOMP

d. XTARGET

(easy, L.O. 1, Section 1, a)

21. To use the multiples approach, the analyst must observe certain variables. The variable the analyst will observe is the value:

a. of the comparable firm

b. driver of the target firm

c. driver of the comparable firm

d. All of the answers above are correct.

(moderate, L.O. 1, Section 1, d)

22. When an analyst is looking at several firms whose multiples are not identical, the analyst can use the averaging approach to determine the appropriate multiple. When averaging is used, the analyst must be aware that:

a. the target firm is most similar to the average of comparable firms

b. it is better to use the averaging approach when firms’ multiples are very different from each other

c. firms are comparable even when their multiples are very different from each other

d. All of the above answers are correct.

(difficult, L. O. 1, Section 1, a)

23. Which statement below is incorrect regarding the multiples approach to the valuation of a firm?

a. The multiples approach makes one explicit assumption that the companies’ multiples are equal.

b. The analyst avoids all discounted cash flow assumptions in a multiples valuation.

c. The multiples approach permits the analyst to make discounted cash flow assumptions implicitly.

d. Not all discounted cash flow assumptions are avoided in a multiples valuation.

(difficult, L.O. 1, Section 1, b)

24. Which statement below is an argument supporting the use of the multiples approach?

a. The multiples approach is determined by future cash flows.

b. It is incorrect to use accounting earnings instead of cash flow in a valuation.

c. Due to the popularity of the multiples approach, the value of many firms in the marketplace may actually be based on multiples.

d. Using a single year’s results to estimate value effectively ignores all expected results beyond the first year.

(moderate, L.O. 2, Section 2, c)

25. One problem with using a single year of earnings in the multiples approach is:

a. some firms may have unusual or extraordinary items included in their earnings in a particular year

b. two economically identical firms could report very different earnings amounts if they made different accounting choices

c. value is not related to earnings per se but to cash flow

d. cash flow, not earnings, drives the model

(difficult, L.O. 2, Section 2, a)

26. Which statement below is not a reason why firms trade at different PE ratios?

a. Actual PE ratios are related to earnings growth in the same way a discounted cash flow analysis would predict.

b. Investors consider very few factors in selecting the appropriate PE ratio for valuing a firm.

c. A discounted cash flow analysis would also produce different PEs under different accounting methods.

d. Using a discounted cash flow model, the PE for a firm would change as earnings growth changed.

(difficult, L.O. 2, Section 2, b)

27. The reality is that people use the multiples approach in practice; however they:

a. do not apply it in a simple, mechanistic way

b. apply it in a simple, analytical way

c. apply the same multiple to different firms

d. apply the model in a way that demonstrates how investors should value firms, not how they actually value firms

(moderate, L.O. 2, Section 2, a)

28. Comparable firms need not be similar when:

a. examining the cash flow needs of each firm

b. looking at the growth prospects of each firm

c. a variable exists that does not affect a given multiple

d. analyzing the type of business in which each firm is engaged

(difficult, L.O. 3, Section 3, c)

29. To find comparable firms for a multiples analysis, the analyst would look at all of the following factors except:

a. the firm’s potential for growth

b. the size of the market segment

c. future expected cash flow streams

d. to match firms on industry

(moderate, L.O. 3, Section 3, c)

30. One way in which an analyst can identify comparable firms is to:

a. find firms all of the same size

b. look at the target firm’s list of peer companies in its proxy statement

c. find firms whose present value of discounted expected future cash flows is similar

d. find firms who have many of the same members on each firm’s board of directors

(moderate, L.O. 3, Section 2, b)

31. The first step an analyst should take when using the multiples approach is to:

a. analyze the price/earnings ratio of the target firm

b. analyze the market/book ratios of comparable firms

c. analyze the price/sales ratio of the target firm

d. identify comparable companies

(moderate, L.O. 4, Section 4, d)

32. An analyst should not assume that because firms are in the same industry they are comparable in a multiples approach. Regarding the earnings of potentially comparable firms, the analyst should carefully evaluate to ensure:

a. there are no unusual or extraordinary items

b. the firms are of the same size

c. that the PE ratios of the potential firms create a vast range of values for averaging purposes

d. None of the above answers are correct.

(easy, L.O. 4, Section 4, a)

33. An analyst wants to ensure that the earnings of comparable firms do not include any special adjustments or one-time items. To verify this, the analyst will:

a. look at the economics of the underlying business for the comparable firms

b. examine the projected earnings rates for the comparable firms

c. analyze the capital structures for the comparable firms

d. perform an accounting analysis of the quarterly and annual financial statements of the comparable

firms

(moderate, L.O. 5 & 6, Section 4, d)

34. It is difficult, if not impossible, to find a perfectly comparable firm. Although analysts can find firms in a similar industry with similar products, there are still likely to be differences in growth potential, capital structures, or accounting methods. One strategy for dealing with a situation where the multiple should be less sensitive to differences in important variables is to:

a. adjust the multiple

b. refine the multiple

c. adjust the value driver

d. None of the answers above are correct.

(moderate, L.O. 4, Section 4, b)

35. In evaluating comparable firms, it is still likely that there will be differences in accounting methods. One strategy an analyst might implement to deal with differences in accounting methods is to:

a. switch from using the price/earnings ratio to the market/book ratio

b. switch from using the price/earnings ratio to the price/sales ratio

c. adjust the value driver

d. None of the above answers are correct.

(moderate, L.O. 5 & 6, Section 4, c)

ESSAYS

36. Explain the multiples approach.

Suggested solution:

The multiples approach is used very often in determining the value of firms. When an analyst uses a multiples approach, the analyst assumes the ratio of some firm-specific variable is the same across firms. The ratio is known as the multiple and the firm-specific variable is called the value driver. The analyst can find an estimated value for the firm by multiplying the multiple by the value driver. Several popular multiples are price/earnings (PE), market/book (MB), and price/sales (PS).

Key to the use of the multiples approach is the concept of the comparability of firms. Analysts would expect that two firms in the same industry, with the same earnings, sales, and growth prospects would be comparable in a multiples valuation. Firms need not be comparable in terms of their size to use the multiples approach.

In the multiples approach the firm being valued is called the target. The target firm is valued based on the multiples of another company, known as the comparable firm. The firm-specific variable is called the value driver. An analyst must observe the value of the comparable firm and the value drivers of both the target and comparable firm when working with the multiples approach. For example, to estimate the value of a company’s equity, the analyst uses a ratio such as PE as the multiple, finds comparable companies to determine the comparable multiple, and then applies the appropriate value driver to the multiple (the PE ratio).

(moderate, L.O. 1 & 3, Section 1)

37. Discuss the arguments for and against the multiples approach.

Suggested solution:

Experts debate whether it is appropriate to use a multiple to estimate the value of a firm. There are arguments both for and against using the multiples approach in a valuation. One of the strongest arguments against the use of multiples is that the approach does not use future cash flows to value a firm. The argument states that the multiples approach has two shortcomings. First, accounting earnings, not discounted cash flows, drive a multiple. Second, a multiple uses only one year of results for the firm, not the expected future cash flows of the firm.

The argument that it is incorrect to use accounting earnings instead of cash flow in a valuation has merit, because value is not related to earnings, but rather cash flow. Value should not rest on accounting earnings since such earnings are reported based on various accounting methods and management decisions. This causes earnings to be “managed” with the goal of achieving certain profit goals, reaching bonus targets, and minimizing the impact of debt and leverage decisions. Different firms will also use different accounting methods and different assumptions in calculating their firm’s accounting earnings, leading to problems with comparability. The analyst must complete a thorough accounting analysis to use accounting earnings in a multiples valuation.

The other part of the argument against the use of multiples is that the approach uses a single year’s estimate to value a firm. This procedure ignores the expected earnings results beyond the first year. Future earnings growth can have a large impact on the value of the firm. A single year of earnings for the firm may also include an unusual or one-time item. In such cases, the earnings figure of the target firm may require adjustment to compare it with other firms and their amounts.

The best argument for the use of the multiples approach is that because the approach is used so much today, the value of many firms in the marketplace may actually be based on multiples. The approach is considered valid based on its practical application and accepted use in the financial arena. Even though this argument is not theoretically sound, it is difficult to refute the popularity of the multiples approach in the financial valuation of firms.

(moderate, L.O. 2, Section 2)

38. Identify the strategy an analyst might use when perfect comparability among firms is not possible.

Suggested solution:

Perfect comparability among firms used in a multiples approach may be practically impossible. It is not usually difficult to find firms in a similar industry with similar products. It is likely that there will be differences in the firms’ growth potential, accounting methods, or capital structures, all of which impact comparability.

There are three approaches an analyst might use to deal with situations where perfect comparability among firms is not possible. One approach is to adjust the multiple for differences in important variables. This technique is used when an analyst cannot find a comparable firm with the same earnings growth prospects.

A second approach is to refine the multiple to be less sensitive to differences in important variables that cannot be matched very well. This approach will work in a situation where leverage is a factor in comparability. Since the PE ratio is very sensitive to leverage, it can be redefined on an unlevered basis. This refinement will permit the analyst to compare firms that cannot be matched on their capital structures.

When comparability is an issue among firms due to differences in accounting, the value driver itself can be adjusted to achieve comparability. When the analyst adjusts the value driver for the differences in accounting, the comparable firm’s earnings can be revised to what it would have been under the target firm’s accounting methods before determining the PE ratio of the comparable firm.

(moderate, L.O. 5, Section 5)

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