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Building Sensitivity TablesQuick-&-Dirty Modeling Part I

Understanding Multiples Valuation

On ovember 7, 2010

I remember the first time I was exposed to this valuation multiples stuff. I was in my first job right away out oundergrad school, and I was working for a top asset management firm. I remember I had to go to this investmen

committee in my second day, and we were like 15 people between analysts and portfolio managers. I was pretty

relaxed, until everybody started talking about valuations. I remember that my boss, a pretty good equity portfolio

manager, started asking questions to one of the analysts on my team. This guy was covering LatAm retai

companies, and had started working only one month before me. The conversation was something like this:

Portfolio Manager: Have you researched company X? Its a small cap but Bank Y started coverage las

week

Analyst: Yes I did, its pretty interesting

Portfolio Manager: Whats the Enterprise Value to forward EBITDA ratio?

Analyst: Only four times I dont think it should trade with such a huge discount, I really like the

story

Portfolio Manager: Four times? Really? What are the comps trading at?

Analyst: Seven times forward EBITDA on average

Portfolio Manager What forward EBITDA do you estimate for this company?

Analyst: Forty million as my base case scenario. I talked to the CFO, and he is convinced that they can

reach fifty million of EBITDA next year, but I see that as an aggressive assumption

Portfolio Manager: OK, forty million then Whats the net debt? How many fully diluted share

outstanding?

Analyst: Forty five million of net debt and seventy two million fully diluted shares

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Portfolio Manager: OK so at seven times EBITDA we are talking about an enterprise value of two

hundred and eighty million, and if we take out the net debt we get an equity value of two hundred and

thirty five million, right? Divided by seventy two million shares that is three dollars and twenty six cents

per share if we expect the company to catch up with its peers Whats the price in the market today?

Analyst: One dollar and sixty cents

Portfolio Manager: Thats a huge upside! More than 100% Do you think we should give it a try?

Analyst: I really do I mean, the company just IPOed a month ago and is still to convince investors

that it can deliver, but I really like its management team and all the projections seem reasonable

Portfolio Manager: OK lets put two million dollars and see what happens

I remember this conversation took place in like a minute, before they moved on to discussing another company.

was in shock. What the f*** were they talking about? How did they come up with a target price so fast? I

wasnt sure if these guys were like finance geniuses or I had been ripped off at University, because I didnt have

a clue about what they were talking about, and I was hoping nobody would ask me anything.

Well, neither they were finance geniuses, nor I had been ripped off at University. The fact of the matter is that in

school they taught me what EBITDA was, and we probably reviewed the basic multiples like EV/EBITDA, o

P/E, etc. but in my case I had never realized how to use multiples to value companies.

I spent the rest of my first week studying the basic multiples and the mechanics that they used in the investmen

committee, and luckily I didnt look like a fool when they started asking me questions the following week. I

probably looked like a fool for many other reasons, but not because I didnt know how to use valuatio

multiples.

Once you think about it, using a multiple is the easiest thing in the world. I mean, if you know how to sumsubtract, multiply and divide, you should be able to use valuation multiples. Even a second grader can use them i

he understands the logic.

So, in general, a valuation multiple is simply the result of dividing a financial concept by another financial concept

For example, the P/E or Price-T0-Earnings Ratio is a multiple by which you divide the price of a share by the

earnings per share (EPS) of a company. It basically tells you that if the share price is $10 and the expected EPS

for the next fiscal year (forward EPS) is $2 per share, then the P/E ratio is 5.00x. So you are paying 5 times the

earnings of the company. Now lets assume that I tell you that this valuation is cheap, as all the comparable

companies (comps) are trading at 8.00x. How would you calculate the upside of the share assuming that the

valuation goes from 5.00x to 8.00x? Be careful, what I am about to show you can blow up your mind. So wehave:

Price / EPS = Multiple

$10 / $2 = 5.00x

Now we would like to know what the fair price would be with a multiple of 8.00x, right? So using our supe

advanced math skills we replace 5.00x for 8.00x and we move the $2 to the right, so we get:




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Share this: 1

ew Price = 8.00x * $2 = $16

Thats it! We know that if we expect the companys P/E ratio to go to 8.00x, then the stock price should go to $

16. As simple as that.

So you can use whatever multiple you want and apply the same concept. So going back to the conversation

showed you above, we had:

Enterprise Value (EV) / EBITDA = 4.00x

The analyst believed that this companys valuation should catch up with that of its peers, so he expected that this

multiple would expand to 7.00x. He additionally believed that the company would be able to have an EBITDA

of $40 MM, so they first computed the expected Enterprise Value (EV):

Enterprise Value (EV) = 7.00x * Expected EBITDA

Enterprise Value (EV) = 7.00x * $40 MM = $280 MM

Then they just subtracted the net debt to get the equity value (please refer to chapter III if you dont rememberthis):

Equity Value (or Market Cap) = Enterprise Value (EV) et Debt

$235 MM = $280 MM $45 MM

Then they simply divided the equity value by the amount of outstanding fully diluted shares to get the expected

price:

Equity Value / # Shares = Target Price

$235 MM / 72 MM = $3.26

Done! This is what they did to calculate an expected price for the shares of company X. This method, that is, the

EV/EBITDA method, is one of the most important things you need to know if you want to land a job in

investment banking, private equity, asset management, etc. As you can see, it is very simple; and anybody can do

it, and you can use it in two minutes to rapidly asses a possible value for a company.

We hope you enjoyed this comment. See you in the next one!

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