Valuation Using Growth Adjusted Multiples
Using comparable trading multiples is a common way to value a company or an asset. In an efficient market, it makes sense that investors should be willing to pay roughly the same amount (per dollar of cash flow or earnings, etc.) for two similar companies. But relying too much on multiples can be problematic if we just use them at face value without understanding what information is really embedded.
Every multiple has a numerator and a denominator. The numerator is always some representation of value (i.e. share price, enterprise value). It embeds all the market’s views about the future of the company – after all, investors pay for future results, not historical results. The problem is that the denominator is a financial metric (i.e. EPS, EBITDA) which represents only one year of information. The denominator doesn’t tell us anything about how that financial metric will grow into the future, which is key in deciding how much a company is worth.
Let’s suppose Company A trades at a multiple of 12.0x 2016 projected EPS. Company B is in the same industry and of similar size, but it trades at 9.0x 2016 EPS. An initial reaction might be that Company B is cheap relative to Company A.
But what if we then learn that the consensus 3-year projected EPS growth rate is 8.0% for Company A and 6.0% for Company B? Does this change our assessment? We can use P/E-to-growth multiples (PEG multiples) to get better insight:
|Price / 2016E EPS
|3-year EPS Growth
|PE Mult / Growth
When the earnings growth profile is taken into account, the above analysis would imply that these two companies are actually similarly valued. Using growth-adjusted analysis isn’t perfect, but it can certainly provide more information than using straight multiples alone.