0:35

And I don't think it is complicated, but

I think it's a good idea to get a sense of what it's all about.

As always,

I'm not going to go into too much detail because you can read about it on your own.

I'll give you enough structure so that you can run with it and

apply it and learn as you go along.

So bear with me.

And I will go slowly so that you understand what I'm talking about.

So the topic today is multiples.

And multiples are something that have been used for a long time for two things.

You can either value a whole firm using multiples.

1:16

Or you can combine it with the valuation methods you've already seen,

and I'm going to talk about them in short form.

They're called Discounted Cash Flow methods.

So the methods you've seen in valuation until now, and

this is the last one I'm introducing, is called discounted cash flow.

Simply because of time value of money you've got to discount, and you know that.

However, this multiple method

is used with discounted cash flows to figure out terminal value.

I hope that makes sense to you.

Terminal value is what?

Terminal value is the value of the firm at the end of the horizon.

Right?

So if your horizon for valuing something is only ten years, and you do discounted

cash flows for ten years, the form is not going to go away after ten years, right?

It's going to still be there, especially the entire form.

A project may last shorter intervals, but

a whole form is expected to last essentially forever.

3:04

It´s a ratio and the numerator´s value, of whatever you´re valuing,

and the denominator´s something about the firm or

the entity that is observable by everybody.

So that you are very clear what you´re using and

you´ll see that in a second what I'm talking about.

The two broad kinds of multiples and the two are market and transaction.

So what are market multiples?

Market multiples are multiples that are available for all phones,

even if you go to Yahoo finance you can see ratios like price to earnings.

Price to sales and we'll talk about that in a second.

And other kinds of multiples.

3:49

But then there are transaction multiples.

And transaction multiples are multiples that are associated with

hopefully recent transactions that are similar to the one you're considering.

And often it is about M&A activity So suppose a firm is buying another firm.

4:09

And it wants to value that other firm.

Similar transactions have happened recently hopefully.

And you can use multiples from there,

a value to observable ratio from a similar transaction to value your transaction.

And this is very commonly done.

Leverage buyouts and so on are the examples of it.

So superior recognized that multiples are very simple ratios.

Their simplicity is their strength.

But their simplicity may also be their weakness.

So we'll talk about that in a second.

So, the most important thing to any valuation is, valuation is relative.

I don't know how many time I've said this, but one more time.

Valuation is always relative.

And one of the beauties of the marketplace is that you're able to value things if you

know what the value of a comparable is, right.

So remember, earlier on, we were talking about in my own funny style,

valuing Orange, which is a company very similar to Apple.

5:21

So a brand new activities is very tough to value,

because you do not know what a comparative firm is like.

So whenever you're using multiples, whenever you're using betas,

whenever you're using discounted cash flows.

You got to have the right comparable, and

that's a message that's somehow mentioned only in multiple word.

But it's true of any valuation.

So again, because multiples are another way of valuing stuff, as it turns out,

it's very similar to discounted cash flow, in concept.

You cannot value anything unless you have a comparable available.

And hopefully, that comparable transacts.

6:18

But a very common practice is to figure out the price of your house.

So I don't know if you've been involved in buying and selling real estate.

But when you try to sell a house or

buy a house the way they do it is, they don't know the value of the house.

In fact, figuring out the value of a house is one of the most difficult

things because so much depends upon the eye of the beholder, right?

A dollar's a dollar, but a house I like, you may not like.

So how do you value a house?

You go figure out houses in a similar neighborhood, comparable, first thing.

Second, houses with an observable.

Like number of windows, number of bedrooms, and so on and so forth.

And those observables relative to the value of the house I used to value

your house, because you can observe how many bedrooms are there in your house.

And how many windows are there and so on and so forth, whatever you may want.

Actually, bathrooms are very important.

[LAUGH] So if your value of the house goes up,

the number of bathrooms pretty significantly.

So, the observable characteristics in houses are things like bedroom,

bathrooms, windows.

But the neighborhood is extremely important too.

Because it then makes the comparable relative.

So that's where multiples were used and

still used a lot because you do not have a lot of transactions going on, right.

On the other hand, if you have a stock price available,

it transacts every day, houses don't.

They are very expensive to transact.

It gives you some flavor.

So, let me talk about two kinds of multiples we'll talk about.

One are called equity multiples.

7:55

So, for example, equity means the value of shares.

So, what is the multiple that we'll consider?

There are a couple that we'll talk about.

One is price to earnings ratio.

So P divided by E is a very commonly coded go to any financial press you see it.

8:14

Often, there's price to sales multiples too.

So think a little bit about what is sales and what is earnings and

what's the difference between the two.

While we talk about it, talk about these issues.

So the first is equity multiples.

The second kind of multiples we'll talk about

a lot are called firm value multiples.

And the reason we are talking about firm value multiples should

be very obvious to you, that firms are financed often by both equity and debt.

8:49

So that's why we worry a lot about full multiples.

And they are typically, enterprise value of the firm, which is stuff

we have talked about, divided by EBITDA, E-B-I-T-D-A, right, EBITDA.

You know all this stuff, so I'm taking the liberty of just talking about it.

So that you understand what I'm talking about.

We'll do an example at the end.

But as I said, we are so far along in valuation,

that talking about multiple is easy now, because you know what I'm talking about.

Another multiple could be enterprise value to sales.

So remember that the enterprise value simply the value of the total firm, and

it'll be the value of the equity if there is no debt.

But there often is debt.

So we have to worry about how to value the whole firm.

9:38

One you have seen how these multiples work,

you'll be able to create your own multiples, right?

So, often this happens when you don't have enough information.

So for example, in the dot-com boom.

People used a lot of eyeballs to value stuff.

In fact, it's still used.

9:58

And number of eyeballs is farther removed from sales, right?

So but still, if you don't have information, you create your own multiple.

Again, that's a strength of a multiple.

But it's also a weakness.

And I want to go into some depth today.

So that you understand why multiples are so cool and why they are not.

So that I would like you to stare now at the picture up there, and

this is a picture of you so often.

10:43

When you're doing detailed cache flow based evaluation we took care of all

of this.

Remember leveling and leveling, accounting for growth and

terminal value and all that.

Here the way you want to think about it, multiples are hiding more information,

not because they want to but because they're simple.

So let's start with a simple graph.

What do you have under assets, real assets?

What's more important, is what do you have under liabilities.

We have not debt right now.

So the value of the firm is the value of equity.

Please keep that in mind.

11:31

That is one year from now.

Remember, all valuation starts if the first cash flow is one year from now.

Why are we calling it free cash flow?

Because that's a terminology quite common in finance.

And free cash flow is the total cash flow available for distribution in a particular

year, after you've deducted from say, revenues, all the costs, etc.

So your free cash flows, let's assume that it's going to last forever.

In other words, your firm is lasting forever.

And for simplicity you want to just figure out what the value of the firm is.

So the first cash flow is FCF one.

12:46

Right, this is the good old formula that I've always told you,

one of the most used formulas in the world.

It says, that there's no growth going on.

So the value of the firm is simple perpetuity formula.

12:58

The one thing I've replaced in the perpetuity formula is I've

replaced C by F c of one.

But the 1 is importaonet, one year from now.

Make sense?

Okay.

Let's keep going.

Suppose I divide both sides of that equation by FCF of next year.

So will it work out to be?

I will have v0/FCF1 is

equal to one over r.

You can see that, you can do that, what is this telling you?

Just stare at the ratio on the left hand side.

What is that ratio?

That's a multiple.

13:40

Remember what's in the numerator?

I said the value of the whole fund.

What's the denominator?

Free cash flow in period one.

Quick question.

I'm assuming, and it's a question and a statement on my part,

I'm assuming that you're able to figure out what free

cash flow in first tier is because if you can't figure that out.

We are at right at the beginning.

So let's assume that free cashflow in period one is observable, or

you can estimate it.

So this ratio becomes equal to one over r, where r is what?

The discount rate.

So the first thing that you recognize in all of this is that r reflects what?

Please go back to the fundamentals.

Here, r is the return on assets.

It also happens to be return on equity, because there's no debt.

That's why I'm starting very simple.

But the r reflects the riskiness of the business.

So the first thing when you look at the comparable is that it is one over r.

14:51

And r is a fundamental reflection of the business risk.

So when you go to value something, your comparable has to be in the same business.

Or in a similar risk, and something called SIC Codes are used for classifying

companies within various industries, and you will see that available on the net.

And that's one basis for choosing comparables.

You can get very fine, but the only warning I am making is when you

are evaluating something don't go by a broad category.

So for example, if you ever had a airline company you're starting,

don't look at other airlines.

Because if you are, for example, a luxury airline, or a private jet.

It's a very different business than a commercial with a lot of passengers.

So keep that in mind, and we've talked about that a lot already.

15:53

So suppose there is growth.

So there is growth firms in an industry and no growth firms.

But for the time being let's assume there's no debt.

Now, if the first year's cash flow,

free cash flow is FCF one in the next year, and

you expect it to grow at rate g and last forever.

What is the value of the firm?

Let's just quickly write it out.

Value of the firm V ought is

equal to FCF one over r minus g.

This formula is pretty straight forward too.

In fact, this is a general formula for the previous one that we saw.

16:44

Growth seems to matter to the valuation, right?

As it should.

So what I'm going to do now is, I'm going to create the ratio again.

So let's look at the ratio value to free cash flow.

Divide both sides by FCF1.

So V nought divided by FCF one be

equal to one over r minus G.

17:10

You see simple thing has changed the dynamic a little bit.

In the earlier equation you had just one over r.

And you had to only worry about the business risk of the comparable.

But now you have to also worry about what?

The growth.

All else remaining the same, firms with growth will have higher values.

All else remaining the same, firms with growth will have higher values.

So therefore when you look at a comparable firm to value yourself,

what do you have to worry about?

17:44

Because if you don't think in those terms, you'll be comparing apples to oranges.

So, one bottom line, if there's no debt.

You need to worry about picking comparables whose multiples you use to

figure your value out who are in the same business and with similar growth patterns.

Same business, and similar growth patterns.

What we're going to do now is I'm going to let you reflect on this a little bit.

Play around a little bit with the ratios we have done.

We're going to take a break and come back.

And pick up with some more interesting aspects of multiples.

See you in a minute.