Question

8. The multiples we select from comparable companies are really fractions. An analyst has to be very careful when he or she uses a multiple to be sure that the numerator and the denominator "match". In what sense do they have to match? What is this relationship called? Would a multiple that is computed as Price/EBITDA match? Briefly, why or why not?

Answer 1

Solution:-

Every multiple used for peer comparison and relative valuation purposes is a ratio and every ratio is a relative relationship between the numerator and denominator. A ratio is just a number but it is the relationship between the numerator and denominator that gives meaning to that number. If there is no logical and meaningful relationship between the numerator and denominator, the ratio is useless and means nothing.

This holds as much strongly for multiples used in valuation as it holds true for any other ratio. The multiples helps us understand the valuation of a company relative to the valuation of its comparable competitors. This helps us get a hang of their relative valuation and the attractiveness of various opportunities in an industry.

An analyst must make sure that the multiples deliver the purpose they are being used for. If a multiple is used to understand if a stock is undervalued or overvalued, the analyst must ensure that the multiple has the required numerator and denominator whose interplay displays the valuation of business. If the relationship of numerator and denominator doesn't tell logically tell about the valuation of stock, than the analyst must not use it.

This relationship is called relative meaning with one another or relative valuation in the parlance of valuation multiples.

Price/EBITDA is a classic example of a ratio multiple whose numerator and denominator don't match with one another for the following reasons:

• Price reflects the market value of one equity share where as EBITDA reflects the total earnings of the company and not just earning per share
• EBITDA reflects the earnings attributable to all stakeholders in the company including debt hloders, preference shareholders and equity shareholders. When we take an amount in the numerator which reflects the value of equity in numerator, we must take only those earnings in denominator that are related to equities and not other stakeholders
• This is the reason that investors either use EV/EBITDA ratio which compares the company's total enterprsie value (value for all stakeholders combined) with EBITDA, or Price to earnings ratio which compares an equity share price with earnings per share

This is why it is important that the numerator and denominator makes sense relatively for the ratio to hold any meaning which can used by investors to draw meaningful conclusions. Unrelated variables in the form of numerator and denominator don't serve any purpose and are useless.