0:08

Welcome back.

We are talking about multiples and

in the next segment I'm going to provide you enough detail that we can conclude.

Please remember what we talked about is that we started out with the firm with

no debt to make things simple when you use multiples you pick

compatibles in the same business with similar growth.

We then started worrying about what in the real world is used.

It's good to talk about theory.

0:37

We realized that a lot of people used price to earnings multiples simply because

free cash flows are choppy, and earnings are literally available.

Having said that, you have to remember that earnings are not free cash flows.

They are less choppy bu,t they're not free cash flows.

So you to worry about some issues with earning and see how they behave.

But most importantly, you have to adjust for

growth which is the approximate adjustment of the for the b bag ratio.

And you have to worry a lot about debt.

1:11

So as long as there was no debt, P ratios can be more or

less used because the effects of leverage are complicated.

And if there's no leverage you don't have to worry about it.

But the real world has leverage.

So you go, you want to start a new firm called Orange, or

you're going to start a firm very similar to a retail business.

Call it whatever you want.

You want to look comparables.

And you find comparables in the same business, similar growth and so

and so forth.

But you can't use PE ratios because they're contaminated.

So what's the alternative?

2:01

E-B-I-T-D-A.

Earnings before interest, taxes, depreciation, and amortization.

We have talked about this a lot.

So I'm just going to say it.

I'll show you some numbers in a second.

So though P/E ratios is most commonly quoted in the financial

press in valuation, given that data's fairly frequently used.

Enterprise value multiples are much more widely used.

What is enterprise value?

Enterprise value is the value of the whole firm.

2:34

Not just the value of equity, it´s the value of equity plus debt and

we´ll see that you subtract the value of excess cash flows.

And I´m going to talk about that briefly here and

not too much in detail because excess cash flows.

Think of them as cash flows you have, which have nothing to do with your current

business, but you may be carrying them to invest in some future businesses.

So enterprise value is the value of equity plus debt.

And typically if you have excess cash flow, you subtract it.

So, that's the numerator.

Instead of price, enterprise value.

But the denominator has to change as well, so what do you have?

EBITDA.

Remember, you haven't subtracted interest and

you haven't subtracted depreciation and amortization and taxes.

So this is the most commonly used.

Again, the logic being it's less choppy.

Then free cash flows, which can also be negative, right?

3:32

So that's the multiple we'll talk about.

Enterprise value divided by EBITDA.

Again, if you look at the screen.

I have defined Enterprise Value as equity plus debt minus excess cash.

3:46

How does this change with leverage?

So how does this ratio, enterprise value over EBITDA, change with leverage?

Well, think about it.

It is still contaminated somewhat.

So leverage, though distinctly is not being accounted for

in EBITDA, the denominator, because we kept interest there.

You know enterprise value will increase with leverage, right?

Because, what happens?

The same way as equity value goes up,

because of the subsidy provided by the government, for

the interest payment on debt, effects value of the whole firm as well.

4:25

So some thoughts on it.

Ideally, what would you do about enterprise value?

You would try to remove present value of the tax shields,

and also try to remove the effects of financial distress, okay?

So that you're left with a pure kind of value of

the very tough to do in real world.

So we tend not to do it.

It's very, very tough to do all this.

4:52

EBITDA, however, so

that's enterprise value, EBITDA also has some non-operational items, right?

So for example, if you have operating leases.

The rental expense includes interest costs.

5:25

For both enterprise value and EBITDA.

So I've just highlighted some of the things that you need to worry about

to adjust given enterprise value and EBITDA multiples.

But at least they don't suffer as much as PE

ratios blatantly suffer from leverage.

Okay?

And we just want to give you an example to end it all so

that you understand what it's all about.

So I'm going to put up some numbers.

And we'll give you all this information for you to stare at and

we'll do calculation.

These are real world numbers.

So what I did was on November 4th, 2014.

I was just fooling around creating this slide, and

I took some information and the following data was available on Apple.

The market capitalization of Apple if you stare was about $636.92 billion.

A lot of money.

But Apple is doing pretty well.

So market capitalization.

What does that mean?

It's the value of the stock, remember?

We have done all this in the specialization.

So market capitalization means value of the equity.

6:39

Debt from the balance sheet is 35.30 billion.

You notice that Apple doesn't have too much debt, but

it's not zero either, right.

So I've just taken this number from the balance sheet.

Again going back to all the valuation we have done.

I want to remind you that sometimes we have to take numbers from the balance

sheet because debt doesn't trade every day.

So many times you have to deal with book value.

Turns out, excess cash I calculated.

This is cash sitting around,

which has nothing to do with the fundamental existing business of Apple.

So you excess cash about 20.47 billion.

7:17

Please jot down these numbers as we go about.

And enterprise value is 65, 651.75 billion.

I will not tell you how I calculated it, it's pretty straightforward,

given all the numbers.

What do you do?

7:34

Equity plus debt, minus excess cash.

So I have given you a number for enterprise value,

which is the numerator off a multiple based on EBITDA.

So let me give you the EBITDA number.

7:49

The EBITDA number turns out to be 60.45 billion.

Do you have all the information out there?

Stare at it.

We are now going to take a break,

because these calculations are pretty straightforward.

But I would like you to just make sure you jotted down all the numbers.

One more time, 636 billion approximately is value of equity.

35 billion approximately is value of debt.

20, 21 billion approximately is value of excess cash flow.

Therefore enterprise value turns out to be about $651.75 billion.

8:26

EBITDA, which is easy to figure out from the accounting statements,

turns out to be and on that specific date, 60.45 billion.

Okay?

Let's assume that,

that's the EBITDA for next year, just to be sure that we are doing it right.

So what is the Enterprise Value over EBITDA multiple for

Apple on that specific day.

9:14

I'm approximating because we are friends.

It's actually 651.75.

And this is equal to approximately how much?

60.5 billion.

Okay, it's actually 60.45, but we are friends.

Do the ratio and it will work out to be about 10.78.

If you think about it for a second, take a couple of minutes to look at it.

What does this ratio mean?

It's the value of the firm relative to an observable.

Remember, at the beginning?

Multiples are all value, relative to an observable.

So the observable is EBITDA, 60.5, value of the firm 652, so

the multiple is 10.78.

Now let's do one more thing, and you will see.

Suppose I want to figure out continuation autumnal value for

Apple ten years from now.

Let's go ten years in to the future and try to forecast stuff.

So let's assume that the forecast of EBITA you

have done is going to be $91.5 billion.

So what's the value of EBITDA?

Ten years from now you think it's going to be 91.5.

How do you come up with the number?

You obviously assume some growth rate,

which is realistic and not just pulled out of thin air.

You do a lot of research, and we have done that, and

we've come up with a number of 95.5 billion.

We're assuming that the firm is going to grow.

10:51

So what is the value using the current EBITDA of Apple ten years from now?

So assuming that the ratio of enterprise value to EBITDA remains the same at 10.78.

What is the value of the firm projected to be on app.

Remember the observable you first project and then you use the ratio.

Very simple.

And this is the beauty of multiples.

You just multiply 10.78 by 91.50.

Why?

Because you know and if I may write it again.

It is the EV over EBITDA

multiple multiplied by

EBITDA but in which year?

Year ten.

So you just 10.78, you know this number and you know this ratio.

The assumption you're making that the ratio remains the same, right?

So in life you make all these assumptions.

What is the value of the firm?

Almost a thousand billion dollars.

So, basically this is what the value of the firm will be in the future.

And I hope you get a sense of how I got there.

12:11

And, you find the use of multiples in a small context.

The nice thing about multiples is they're extremely simple.

But we did a lot of work on the logic behind them.

I want to comment a little bit on this issue, because many times

people in academia think multiples are too simple and heuristic.

That the real world uses all the time.

12:35

Yes, that's true.

But on the other hand, to discard them outright and

say they don't make sense is discarding the logic of discounting cash flows.

Remember, how did we value, how did we figure out how multiples are determined?

We used c over r minus g essentially to figure out where multiples come from.

So multiples are inherently embedded and based on discounted cash flows.

They're simple because we use simple formulas.

13:08

But having said that, don't just run with multiples.

You got to take care of leverages, growth, similar businesses,

similar business risk Be very careful when you're using simple numbers.

13:21

And to back up your analysis, use multiples, but

always use discounted cash flows in detail.

The more you can forecast, the better discounted cash flows are.

The less you know about the future, then rules of thumb are more useful, right?

So multiples can be useful in a world where you do not know things

with precision,

which is often happens in the VC world or in the world of high uncertainty.