Why Multiples Vary?

Why Multiples Vary?

There are four primary reasons why multiples can vary:

  1. Differences in the quality of the business (ie differences in value drivers)
  2. Accounting differences
  3. Fluctuations in cash flow or profit (i.e. they are unrepresentative of the future)
  4. Mispricing

#1 Business Quality / Value Drivers

All things equal, higher-quality businesses deserve higher valuation multiples. This is another way of saying that there are qualitative differences in the fundamental underlying drivers of valuation, such as quality of management, available investment opportunities, strategy and branding. These can be distilled down to four quantitative valuation drivers: return on capital, cost of capital, growth and duration of growth.

Start by analyzing the three core academic value drivers:

  1. Organic revenue growth
  2. Margin expansion
  3. Capital intensity
  4. Capital deployment
  5. Terminal value perception

As investors, we are interested in how to allow for differences in these value drivers. How much is growth worth? What is the impact of a change in return on capital?

#2 Accounting Differences

Differences in accounting policies that do not affect cash flow do not affect value. But accounting policy differences do affect profit multiples and, as a result, differences in multiples can paint a misleading picture of relative valuation.

For example, consider two identical companies with 20 of goodwill on the balance
sheet and 10 in pre-goodwill profit. Company A does not amortize goodwill while
Company B amortizes over 10 years (amortization of 2 per year).

Since both companies have identical cash earnings they have the same value and should trade at the same share price (same number of shares assumed). This implies an earnings multiple of 25x for Company B. But it clearly would be wrong to conclude that Company A is cheaper than Company B. In fact, there is no information content whatsoever in the difference between the two multiples.

There are many different factors that cause differences in profit measurement; a recent study comparing US GAAP with international accounting standards identified over 250 such differences. Not all of these affect profit measurement but a few issues dominate, including depreciation, goodwill (and other aspects of business combinations), provisioning and deferred tax.

While it is virtually impossible to completely eliminate the impact of different
accounting methodologies, there is still much that the analyst can do to mitigate
their impact and produce data relevant to equity analysis. In particular, one can:

  • Restate accounting data to a common format
  • Focus on key statistics that are less affected by accounting differences (i.e. cash flow, revenue, EBITDA, OpFCF)

#3 Fluctuations in Cash Flow

Multiples are only meaningful if the profit statistic used is representative of the future. Profit fluctuations can have a substantial impact on multiples. Consider a company that has a steady earnings trend but takes a one-off restructuring charge:

Since earnings will recover in 2025, it is unlikely that the price will collapse in 2024 simply because of a temporary drop in earnings; investors will ‘look through’ 2024 earnings and the earnings multiple for 2024 is therefore likely to be very high. A naive comparison of this multiple with that of peers or the sector will not be illuminating and is unlikely in itself to provide an opportunity to identify mispricing.

The market appears to price cyclical earnings efficiently. Fo example. Automobile manufacturers, with their high fixed costs, have notoriously cyclical earnings.

Dealing with Profit Fluctuations

A multiple is only meaningful if the profit on which it is based is indicative of future
profit potential. Where this is not the case, one should:

  • Exclude exceptional items if using historical profits
  • Use forecast rather than historical profits

If current/subsequent years’ profits are still unrepresentative of the longer term, then one should (a) use normalized profit or cash flow; or (b) consider using ‘forward-priced’ multiples.

#4 Mispricing

If differences in multiples are not fully explained by differences in business quality, accounting differences or profit fluctuations, then the stock may simply be mispriced. It is the analyst’s task to identify mispricing; the analyst’s skills is in distinguishing between differences arising from underlying fundamentals – and therefore justified – and those arising from mispricing.

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