You will be able to calculate the main valuation multiples and say what each one is a shortcut for.
A broker note lands in Marcus's inbox the week after he finishes his Larkspur valuation. It says Larkspur trades at about 11 times earnings, cheap for its sector. His DCF from module 8 says the shares are worth about S$1.80 against a price of S$1.60. Do the two agree? He can't tell yet, because "11 times earnings" is a different kind of statement from a DCF. It's a shortcut, and every shortcut leaves something out.
A valuation multiple divides a price by one line of the accounts. The whole market quotes them, because they take seconds to calculate and let you line up dozens of companies at once. This module uses them to cross-check the DCF, and this lesson sets out what each common multiple measures. Larkspur's figures are made up and in S$ millions unless stated, taken from the FY5 accounts you met in module 7.
Think of a multiple as a DCF that has been squashed into one number. When the market pays 11 times this year's profit, it's making a judgement about growth, risk and how much the business must reinvest, all at once, without writing any of it down. Your DCF made you write those things down. The multiple tells you what the market concluded, and the two together tell you where you disagree.
One simple case shows the link. If a company paid out all its profit and never grew, the return you'd earn from buying at a P/E of 11.4 would be one divided by 11.4, about 8.75% a year. That figure, profit divided by price, is the earnings yield. Any growth is a bonus on top, and any extra risk is a reason to demand more.
The price to earnings ratio, or P/E, divides the share price by earnings per share. It compares what you pay with the profit that belongs to shareholders after interest and tax.
The answer depends on which earnings you use. Larkspur's reported profit of 48 is 16 cents a share, which gives a P/E of 10.0. Its underlying profit of 42, from lesson 6.6, Adjusted earnings and how to reconcile them to reported figures, is 14 cents a share, which gives 11.4. On next year's forecast from lesson 7.8, about 15 cents a share, the forward P/E is about 10.7. Three honest-looking numbers for one company on one day. Always write down which earnings sit underneath, and use the same kind for every company you compare.
P/E ignores debt. Two companies with the same business and the same share price can have very different P/E ratios if one has borrowed heavily, which lesson 9.2 shows with numbers.
Enterprise value fixes that by valuing the whole firm, the shareholders' part and the lenders' part together. It's market value plus net debt. Larkspur's equity is worth 480 at S$1.60 a share, and its net debt, including leases, is 20, so its enterprise value is 500. Divide by EBITDA of 80 and you get EV/EBITDA of 6.25 times. Because both sides of that ratio belong to everyone who funds the company, it compares companies fairly whatever their mix of debt and equity.
EBITDA leaves out depreciation, and for a machine shop like Larkspur, machines wear out and must be replaced. So analysts often check EV/EBIT as well: 500 divided by operating profit of 56 is about 8.9 times. Leases need the same care on both sides of the ratio, because under SFRS(I) 16 lease costs sit below EBITDA, so the lease liability belongs in enterprise value, as Larkspur's figure of 20 already allows.
Price to book value divides market value by shareholders' equity on the balance sheet. Larkspur's 480 against book equity of 285 is about 1.7 times. P/B suits businesses whose assets are mostly financial or tangible and valued close to market, such as banks, insurers and property companies. Lesson 8.7, Valuing banks and REITs, where a standard DCF breaks, showed that a bank's fair P/B depends on its return on equity, and the same logic applies here: Larkspur earned about 15.6% on its average equity in FY5, which is why it trades above book.
Price to sales divides market value by revenue. Larkspur's is 1.2 times. It's the multiple of last resort, used for companies with no profit yet, because revenue at least exists, and it says nothing about margins. A company with a 2% margin and one with a 20% margin can share a P/S ratio and be worth wildly different amounts. If you use a sales multiple, use EV to sales so debt is counted, and put the margin beside it.
Free cash flow yield turns the P/E upside down and swaps profit for cash. It's free cash flow divided by market value. Larkspur's free cash flow after lease payments was 28, from lesson 7.4, Cash flow statement and free cash flow, so its yield is 28 divided by 480, about 5.8%. Before lease payments it's about 6.7%.
Cash is harder to dress up than profit, which makes this the multiple short sellers and sceptical analysts reach for first, though it has a weakness of its own: free cash flow swings with spending decisions, so a company that delays buying machines looks better for a year, and one that invests heavily for growth looks worse. Check it over several years, as you did in module 7.
Marcus wrote Larkspur's line in his workbook: P/E 11.4 on underlying profit, EV/EBITDA 6.25, P/B 1.7, free cash flow yield 5.8% after leases. On its own, that line says nothing about cheap or dear. It becomes useful when it sits beside the same figures for similar companies, which lesson 9.3 sets up. Your model already holds every input you need for your own company's line.
Calculate P/E, EV/EBITDA, P/B and free cash flow yield for your modelled company from your model's figures.
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