Calculate the main valuation multiples and say what each one is a shortcut for.
Open the model you built for your own company and find these figures: the share price, earnings per share, net debt including leases, EBITDA, operating profit, book equity and free cash flow. Each common valuation multiple is built from two of them.
A valuation multiple divides a price by one line of the accounts. The whole market quotes multiples because they take seconds to calculate and let you line up dozens of companies at once. In this module you use them to cross-check your DCF. Every multiple is a shortcut, and every shortcut leaves something out, so you need to know what each one measures before you can put it beside a DCF result.
Marcus finished his DCF of Larkspur, a machine shop company, in module 8. It put the shares at about S$1.80 against a price of S$1.60. The week after, a broker note arrived saying Larkspur trades at about 11 times earnings, cheap for its sector. Marcus couldn't yet tell whether the note and his DCF agreed, because "11 times earnings" is a different kind of statement from a DCF. All Larkspur figures here are invented examples, in S$ millions unless stated, taken from the FY5 accounts in module 7.
A multiple is like a DCF squashed into one number. The price someone pays reflects a judgement about growth, risk and required reinvestment, made all at once without writing any of it down. A DCF forces you to write those assumptions down. The multiple shows what the market concluded, and putting the two together shows where you disagree with the market.
Turning a multiple upside down helps. Earnings yield is profit divided by price, the inverse of P/E. For a company that pays out all its profit and never grows, the return from buying at a given P/E equals 1 divided by the P/E. A P/E of 11.4 gives 1 / 11.4, about 8.75% a year. Growth is a bonus on top of that, and extra risk is a reason to demand a higher return.
P/E, the price to earnings ratio, is the share price divided by earnings per share. It compares what you pay with the profit belonging to shareholders after interest and tax.
The answer depends on which earnings you use. Larkspur's reported profit is 48, which is 16 cents a share, so the P/E is 1.60 / 0.16 = 10.0. Its underlying profit from lesson 6.6, "Adjusted earnings and how to reconcile them to reported figures", is 42, or 14 cents a share, giving 1.60 / 0.14 = 11.4. Forward P/E uses next year's forecast earnings: on the forecast of about 15 cents a share from lesson 7.8, Larkspur's forward P/E is about 10.7. Always record which earnings sit underneath, and use the same kind for every company you compare.
P/E also 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, and lesson 9.2 works through this with numbers.
Enterprise value (EV) values the whole firm, the shareholders' part and the lenders' part together. It is the market value of equity plus net debt. At S$1.60 a share, Larkspur's equity is worth 480. Net debt including leases is 20, so EV is 480 + 20 = 500.
EV/EBITDA divides enterprise value by EBITDA. It compares companies fairly whatever their mix of debt and equity, because both sides of the ratio belong to everyone who funds the company. Larkspur's EBITDA is 80, so EV/EBITDA is 500 / 80 = 6.25 times.
EBITDA leaves out depreciation. In a machine shop like Larkspur, machines wear out and have to be replaced, so analysts often also check EV/EBIT, where EBIT is operating profit. Larkspur's operating profit is 56, giving 500 / 56 = about 8.9 times.
Leases need the same treatment on both sides of the ratio. Under SFRS(I) 16, lease costs sit below EBITDA, so the lease liability belongs in enterprise value. Larkspur's net debt figure of 20 already includes leases.
P/B, price to book, is market value divided by shareholders' equity on the balance sheet. It suits businesses whose assets are mostly financial or tangible and valued close to market: banks, insurers and property companies. A bank's fair P/B depends on its return on equity, as lesson 8.7, "Valuing banks and REITs, where a standard DCF breaks", shows. The same logic applies to Larkspur. Its book equity is 285, so P/B is 480 / 285 = about 1.7 times, and it trades above book because of its return on average equity of about 15.6% in FY5.
P/S, price to sales, is market value divided by revenue. It is the multiple of last resort, used for companies with no profit yet, because revenue at least exists. Larkspur's P/S is 1.2 times. P/S 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 do use a sales multiple, use EV to sales so debt is counted, and put the margin beside it.
Free cash flow yield is free cash flow divided by market value. It turns the P/E upside down and swaps profit for cash. Cash is harder to dress up than profit, so this is the multiple short sellers and sceptical analysts reach for first. Larkspur's free cash flow after lease payments, from lesson 7.4, "Cash flow statement and free cash flow", is 28, so its FCF yield is 28 / 480 = about 5.8%. Before lease payments it is about 6.7%, so state which one you are using.
Free cash flow swings with spending decisions. A company that delays buying machines looks better for a year, and one investing 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 whether Larkspur is cheap or dear. It becomes useful only beside the same figures for similar companies, which lesson 9.3 sets up.
To build the same line for your company, work through these in order:
P/E: share price divided by EPS, noting whether the earnings are reported, underlying or forward Enterprise value: market value of equity plus net debt, including lease liabilities EV/EBITDA, plus EV/EBIT where depreciation matters, with leases treated the same on both sides P/B: market value divided by book equity, read alongside return on equity P/S only where there is no profit, as EV to sales with the margin beside it FCF yield: free cash flow divided by market value, stating before or after lease payments, checked over several years
Write the results in your workbook as one line, ready for the comparison in lesson 9.3. Your model already holds every input you need for your own company's line.
Use the figures in your model to work out P/E, EV/EBITDA, P/B and free cash flow yield for the company you modelled.
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