P/E AND P/B MULTIPLES AND COMPANY S FINANCIAL STRUCTURE. Dragoş MÎNJINĂ *

Transcription

1 ANALELE ŞTIINłIFICE ALE UVERSITĂłII ALEXANDRU IOAN CUZA DIN IAŞI Tomul LV ŞiinŃe Economice 2008 P/E AND P/B MULTIPLES AND COMPANY S FINANCIAL STRUCTURE Dragoş MÎNJINĂ * Absrac Muliples play an imporan role in valuaion. P/E and P/B muliples are in negaive relaion wih he cos of, which in urn is influenced by risk and ineres rae. The P/E muliple is mainly driven by fuure earnings growh, whereas he major drivers of he P/B muliple are fuure reurn on common (ROCE) and growh in book value of. For P/E muliple is also imporan he reurn on invesed capial (ROIC). In he real world, financing decisions lead o he modificaion of boh valuaion muliples and eniy valuaion muliples. In spie of he fac ha he former muliples caegory is heoreically more affeced, he empirical sudies reveal a greaer performance of he valuaions based on hese muliples. The relaion beween marke-o-book raio and leverage raio is no monoonic and is posiive for mos firms. Key words: muliple, P/E, P/B, financial srucure, valuaion JEL classificaion: G12, G32, G11, G39, M41 1. Inroducion Muliples play a paricularly imporan role in assessing he value of firms. The muliples valuaion mehod knows a large use. In his sense, Damodaran presens he resuls of a sudy conduced on 550 research repors carried ou by invesmen banks in he Unied Saes, London and Asia in he firs half of 2001 where he raio of relaive valuaions (by muliples) and discouned valuaions (1) is nearly 10 o 1 [Damodaran, 2006, Chaper 7, 2]. Furhermore, Bonadurer noices he conclusion of a repor of Morgan Sanley Dean Wier published in 1999 ha only 20% of he analysis focuses on discouned cash flow mehod, while a much higher percenage uses for valuaion differen muliples based on profis [Bonadurer, 2003, 7]. The presenaion ha Fernandez makes for he mos widespread mehods used by analyss a Morgan Sanley Dean Wier for European companies shows ha he assessmen by muliples occupies hree places in he firs four (1.P/E, 2.EV/EBIT, 4.EV/EG) while discouned cash flow valuaion is only he fifh [Fernandez, 2001, 2]. * Dragoş MÎNJINĂ (dminjina@yahoo.com) is PhD suden a Buchares Academy of Economic Sudies, Faculy of Insurance, Finance, Banking and Sock Exchanges, Academy of Economic Sudies, Buchares -Romania. His research ineress include: capial markes, muliples, informaional efficiency.

2 104 Dragoş MÎNJINĂ 2. Muliples a general presenaion Muliples play a paricularly imporan role in assessing he value of firms. The muliples valuaion mehod knows a large use. In his sense, Damodaran presens he resuls of a sudy conduced on 550 research repors carried ou by invesmen banks in he Unied Saes, London and Asia in he firs half of 2001 where he raio of relaive valuaions (by muliples) and discouned valuaions (1) is nearly 10 o 1 [Damodaran, 2006, Chaper 7, 2]. Furhermore, Bonadurer noices he conclusion of a repor of Morgan Sanley Dean Wier published in 1999 ha only 20% of he analysis focuses on discouned cash flow mehod, while a much higher percenage uses for valuaion differen muliples based on profis [Bonadurer, 2003, 7]. The presenaion ha Fernandez makes for he mos widespread mehods used by analyss a Morgan Sanley Dean Wier for European companies shows ha he assessmen by muliples occupies hree places in he firs four (1.P/E, 2.EV/EBIT, 4.EV/EG) while discouned cash flow valuaion is only he fifh [Fernandez, 2001, 2]. Muliples valuaion is realized in four sages [Shreiner, 2007, 49 53]. The firs wo sages involve he selecion of a relevan value driver and idenificaion of comparable companies, he peer group. A muliple is calculaed as he raio of marke prices and a value driver. The hird sage is devoed o muliples aggregaion a he level of each group of comparable companies wih he calculaion of a synheic muliple. Finally, o deermine he value of he analyzed company, he synheic muliples for comparable groups are muliplied wih he corresponding value drivers of he valued companies. Populariy of muliples valuaion is due o he following reasons [Damodaran, 2006, Chaper 7, 3-4] (2): 1) consumes less ime and resources han discouned cash flow valuaion; 2) i is easier o be sold; 3) i is easier o be defended; and 4) reflecs he curren sae of he marke. However i mus be noed ha in heory he preferred valuaion mehod is discouned cash flow mehod. (3) Fernandez claims ha muliples are used in a second sage of evaluaion: afer valuaion by oher mehods, a comparison wih muliples of comparable companies allows he assessmen of he realized valuaion and he idenificaion of he differences beween he assessed company and he companies wih which i is compared [Fernandez, 2001, 2]. According o Goedhar, Koller and Wessels (2005) a careful analysis conduced by comparing he muliples of a company wih hose of oher companies may be useful in achieving he necessary forecass for discouned cash flow valuaion and, implicily, i may increase he accuracy of such valuaions. Execued properly, such analysis can help a company o conduc sress ess (4) for is forecass regarding he cash flows, o undersand he differences beween is performance and hose of is compeiors and o evaluae wheher a company's sraegic posiioning enables he creaion of more value han oher players in he indusry. An analysis of muliples can also generae he undersanding of he key facors ha creae value in an indusry [Goedhar, 2005, 7]. A he same ime i deserves a place in any se of valuaion ools [Goedhar, 2005, 11]. The same idea is suppored by Damodaran who believes ha he relaive assessmen has a role o play which is separae and disinc from he discouned cash flow valuaion [Damodaran, 2006, Chaper 7, 3]. According o Penman (2005), (marke) muliples are defined as he raio beween a marke price (such as he price of he shares, marke capializaion or he enire value of he company) and a value driver of he company (which may be made up of earnings, income or

3 P/E and P/B muliples and company s financial srucure 105 employmen). Therefore muliples are synheic measures ha provide informaion on he marke value of a company compared wih hose of compeiors. From he diversiy of he muliples ha can be compued, P/E and P/B are disinguished by a considerable populariy. Among he mos common mehods used by analyss from Morgan Sanley Dean Wier o evaluae European companies presened by Fernandez (2001), he P/E mehod occupies he firs place, being used by over 50% of analyss while he P/B mehod is on he sixh place being used by over 15% of analyss. Observing he high accuracy of valuaion wih daa from he Unied Saes compared wih hose of he valuaion made wih European daa, accuracy based on he use of four muliples (i.e., railing P/E, one-year forward-looking P/E, he wo-year forward-looking P/E and P/B muliple), Schreiner and Spremann remark he populariy of P/E and P/B muliples among paricipans on he capial marke in he Unied Saes ha has an impac on he marke prices level US socks [Schreiner, 2007, 19]. 2. Value drivers ha affecs P/E and P/B muliples Derivaion inrinsic muliples from he fundamenal valuaion models for socks based on dividends, (free) cash flows and (abnormal) earnings, which involves he calculaing of he discouned values of fuure expeced inflows (5), allows he idenificaion of muliples value drivers. In he case of P/E, he equaion obained (6) shows a posiive relaionship wih fuure growh (of earnings) and a negaive one wih he risk, measured by he cos of. In he case of P/B muliple, he obained equaion (7) shows ha he muliple is a funcion of he expeced profiabiliy, as measured by ROCE, of is risk, measured by he cos of, and is growh (of book value of ). v B ( 1 g ) v PR + r - g = 1+ = (1) ( ROCE r ) B ( r - g ) ( 1+ r ) where v = inrinsic value of a company, = ne income in year, PR = dividend payou raio, g = growh rae of ne income, r = risk adjused expeced rae of reurn, B = book-value of in year, ROCE = common shares reurn in year, equal o he / B -1 raio and g B = growh rae of book value of. From he above equaions defining he inrinsic value of P/E and P/B muliples is observed ha he expeced rae of reurn is in negaive relaionship wih boh muliples. In urn, his relaionship suggess a negaive relaionship wih risk and ineres raes, he wo componens of he expeced reurns. (2) 3. P/E muliple and he financial srucure Chadda, McNish and Rehm poins ou ha he growh rae and P/E muliples does no necessarily evolve in he same sense and wih he same magniude. High muliples may be

4 106 Dragoş MÎNJINĂ he resul of high reurns of capial for businesses wih average or lile growh, as may be he resul from high growh. Growh accompanied by a low reurn on capial will no lead o a high P/E muliple, because i does no creae value for shareholders [Chadda, 2004, 12]. In addiion o he posiive relaionship beween P/E muliples and he fuure growh of earnings and he negaive relaionship beween hem and ineres raes and risk (8), lieraure also ake ino consideraion he impac of financial srucure on he value of P/E muliple. Goedhar, Koller and Wessels observe he improper applicaion of muliples in he valuaion based on P/E muliples calculaed as he average of indusries in which valuaed companies are par (synheic muliples ha hen are muliplied wih he corresponding value driver, i.e. ne income in his case) because he companies wihin indusries are characerized by values quie differen of expeced growh raes, of invesed capial reurns and of he capial srucure [Goedhar, 2005, 7]. Alford idenifies lieraure ha suggess ha could be useful he conrol for he leverage differences among comparable firms if hese differences are large (9), bu he resuls of he realized es (10) srongly indicaes ha he leverage adjusmen is no effecive [Alford, 1992, 104]. In heory, he level of deb (more precisely he srucure of capial) can cause problems ha decrease he accuracy of valuaions based on valuaion muliples. Goedhar, Koller and Wessels noes he sysemaic effec on P/E muliples of he capial srucure, his being one of he major shorcomings of P/E muliples [Goedhar, 2005, 9-10]. This deficiency causes hem o lis among he basic principles ha can help companies o properly apply muliples, using of eniy valuaion muliples (for example of EV/EBIT muliple insead of P/E muliple). Schreiner illusraes he sysemaic relaionship beween financial srucure and P/E muliple in a real Modigliani and Miller (1958) world, wihou axes, coss of financial disress and oher agency coss, deriving he equaion below (11) [Schreiner, 2007, 60]. v v v 1 u u u u r 1 ne deb = (3) leverage r ne deb + r 1 ne deb where v u = value of he unleveraged company, u = ne income of he ne deb unleveraged company, equal o EBIT of he levered company, r = cos of deb and leverage = ne deb / eniy value raio. Equaion (3) highlighs hree scenarios in which managers can manipulae he P/E muliples wih decisions on financial srucure. In he case of companies wih unleveraged P/E (muliple ha hey would have had if i would be financed enirely by ) greaer han he reciprocal of he cos of deb, P/E muliples increase wih he leverage. In his way, a company wih an unleveraged P/E muliple relaively high can arificially increase he P/E muliple by increasing leverage. Conversely, many companies wih unleveraged P/E less han he reciprocal of he cos of deb, shows a decrease in P/E muliple as leverage increases. If unleveraged P/E muliple is equal o reciprocal of he cos of deb, leverage has no effec on P/E muliple. In he real world here are axes, coss of financial disress and agency coss ha affec radeoffs beween deb and and make he financial srucure relevan. Modgliani and Miller (1963) shows ha because of axes, using deb insead of decreases he paymens of axes and, herefore, creaes value for shareholders because he laws on ax allow companies o deduc expenses wih ineres bu no paymens of dividends. Tax benefis of a higher leverage are opposed o a higher likelihood of inabiliy o pay he

5 P/E and P/B muliples and company s financial srucure 107 expeced coss and higher expeced coss of financial disress. As compensaion for he increased risk and decreased flexibiliy, shareholders claim a higher cos of and value decreases. The agency coss generally favor he use of deb insead of. If he capial srucure maers, as happens in realiy, he financing decision affecs he value of he company and, hus, indirecly affecs boh valuaion muliples and eniy valuaion muliples (12). Eniy valuaion muliples are less affeced because hey are defined a he firm level (13). However, Schreiner and Spremann es he hypohesis, which ulimaely is confirmed by he resuls of he sudy, ha valuaion muliples are performing beer han eniy valuaion muliples (14) because firs caegory compensae in pracice ha heoreically are more affeced by capial srucure wih he possibiliy of direc observaion of marke capializaion from he numeraor of he muliples raio wih he help of marke prices. Thus he numeraor is no affeced by uncerainy ou of conrol. In addiion, i is aken ino consideraion he fac ha firms in an indusry end o operae wih similar levels of deb [Schreiner, 2007, 7]. 4. P/B muliple and he financial srucure As wih P/E muliple, in addiion o he posiive relaionship beween he P/B muliples and fuure growh of book value of and he negaive one beween hem and ineres raes and risk, lieraure is sudying also he impac of he financial srucure on he value of P//B muliple. Chen and Zhao (2006) consider ha he negaive relaionship beween he marke-o-book value raio (15) (equivalen (16) a he eniy level of P/B muliple), regarded as a measure of growh opporuniies, and leverage represens one of he mos documened rules of empirical lieraure on capial srucure. Mos sudies considered he negaive relaionship as given and are confined o debae economic inerpreaion of i. For example, following agency heory of Myers (1977) (17), many economiss argue ha his negaive relaionship confirms ha firms wih higher growh raes have opimum financial leverage lower. Ohers, in conras, believe ha he relaionship is due o he acive pursui of he marke (18) and he lack of arge leverage raio (19) [Chen, 2006, 2]. Chen and Zhao show ha he empirical base of he debae on he negaive relaionship beween marke-o-book value raio and he leverage is no robus. They urn o a sample of 72,084 firm-year observaions from he period The sample is divided ino hree equal groups depending on he marke-o-book value raio. Companies wih higher markeo-book value raios are on average more profiable (20) and benefi from lower coss for credis (21), suggesing ha in heir case he use of deb is beneficial. The auhors found ha financing hrough deb increased when he marke-o-book value raio increases from low o medium and decreases when he raio increase coninues from medium level o high one. This non-monoonic relaionship suggess ha he widely documened negaive relaionship beween he marke-o-book value raio and deb financing can be deermined by companies wih high marke-o-book value raios. Nonparameric and parameric mehods applied by Chen and Zhao suggess a non-monoonic relaionship beween he marke-o-book value raio and he leverage and mulivariae regression analysis shows ha for mos companies (more han 88% of firms in he COMPUSTAT daabase and more han 95% of marke capializaion) marke-o-book value raio is significan posiive relaionship wih he leverage [Chen, 2006, 2]. The non-monoonic relaionship presened above can be explained by changing preference for sources of funding generaed by he higher imporance of new debs

6 108 Dragoş MÎNJINĂ conracing for firms wih low and medium marke-o-book value raios and by he prioriy ha firms wih high marke-o-book value raios, which have larger reserves (i.e., hey are more profiable), accords o he issuance of shares. Anoher inerpreaion of he analyzed relaionship is provided from he perspecive of he radeoff heory. For companies wih low and medium marke-o-book value, he benefis of leverage are higher han hose resuling from he issuance of shares and companies ake he bes decisions by borrowing more, while companies wih high marke-o-book value raios have high growh opporuniies and mainaining low arge raios is a major concern for hem [Chen, 2006, 7]. 5. Conclusions Financial srucure of a company affecs boh P/E muliple and P/B muliple. Is influence on value is refleced boh on valuaion muliples and on eniy valuaion muliples, he former being heoreically more affeced. However here is noiced a superior performance of valuaion muliples explained by eliminaing he uncerainy caused by muliple numeraor of he muliple formula using he marke capializaion. The relaionship beween he marke-o-book raio and leverage is non-monoonic, being posiive for muliples wih low and medium values and negaive for hose wih high value. References Alford, A., The effec of he se of comparable firms on he accuracy of he price earnings valuaion mehod, Journal of Accouning Research, The Insiue of Professional Accouning, U.S.A., Vol. 30, No. 1, Spring 1992 Bonadurer, W., Valuaion by muliples, Universiy of S. Gallen, Swiss Insiue of Banking and Finance, 2003 Chad, N., McNish, R., Rehm, W., All P/Es are no creaed equal, McKinsey on Finance, McKinsey & Company, No. 11, Spring 2004 Chen, L., Zhao, X., On he Relaion Beween he Marke-o-Book Raio, Growh Opporuniy, and Leverage Raio, 2006, on hp://papers.ssrn.com/sol3/papers.cfm?absrac_id=666845, accessed on Ocober 1 s 2008 Cheng, C.S.A., McNamara, R., The valuaion accuracy of he price-earnings and price-book benchmark valuaion mehods, Review of Quaniaive Finance and Accouning, 15, December 2000 Damodaran, A., Damodaran on valuaion, Wiley, Hoboken, NJ, 2006 on hp://pages.sern.nyu.edu/ adamodar ~ /, accessed on Ocober 1 s 2008 Fernandez, P., Valuaion using muliples. How do he analyss reach heir conclusions?, IESE Business School, 2001, on hp://papers.ssrn.com/sol3/papers.cfm?absrac_id=274972, accessed on Ocober 1 s 2008 Goedhar, M., Koller, T., Wessels, D., The righ role for muliples in valuaion, McKinsey on Finance, McKinsey & Company, No. 15, Spring 2005 Liu, J., Nissim, D., Thomas, J.K., Equiy valuaion using muliples, Journal of Accouning Research, The Insiue of Professional Accouning, U.S.A., Vol. 40, No. 1, March 2002 Liu, J., Nissim, D., Thomas, J.K., Cash flow is king? Comparing valuaions based on cash flow vs. earnings muliples, Financial Analyss Journal, CFA Insiue, U.S.A., Vol. 63, No. 2, 2007

7 P/E and P/B muliples and company s financial srucure 109 Penman, S.H., Financial Saemen Analysis and Securiy Valuaion, McGraw-Hill, New York, NY, 2004 Schreiner, A., Equiy Valuaion Muliples: An Empirical Invesigaion, Academic Nework, Descher Universiäs-Verlag, Wiesbaden, 2007 Schreiner, A., Spremann, K., Muliples and heir valuaion accuracy in European markes, McKinsey & Company, Inc.. and he Universiy of S. Gallen, 2007 Noes 1) The discouned cash flow valuaion mehod associaes he value of an asse wih he discouned value of he cash flows generaed by i. 2) However hese srenghs also means, according o he same auhor, weaknesses: a) he rapidiy of he mehod may lead o inconsisen value, which may no ake ino accoun he key variables such as risk, growh or poenial cash flow; b) he fac ha his ype of valuaion reflecs he sae of he marke leads o overvaluaion when he marke over valuaes comparable companies and o undervaluaion in he converse siuaion; c) lack of ransparency wih regard o assumpions made muliples vulnerable o manipulaion. 3) Managers consider i he mos accurae and flexible mehod for valuaing projecs, companies and divisions [Goedhar, 2005, 7]. 4) Sress analysis is a se of echniques for esimaing losses under exremely unfavorable combinaion of evens and scenarios. 5) The fundamenal valuaion models are: Discouned Dividend Model, Discouned Cash Flow and Residual Income Valuaion Model. 6) equaion (3.16) [Schreiner, 2007, 33]. 7) equaion (3.29) [Schreiner, 2007, 37]. 8) The empirical invesigaions on he deerminans of P/E muliples have found hese relaionships as being weak according o Thomas, J.K., Zhang, H., Anoher look a P / E raios, preliminary sudy, ) I is referring o Lokey, O.K., Braun, R.S., Cephalic, S.L., Business Valuaions in Liigaion Services Handbook: The Role of he Accounan as Exper Winess, Wiley, New York, 1990 and he sudy Pra, S.P., Valuing a Business: The Analysis and Appraisal of closely-held companies, Dow Jones-Irwin, New York, ) The es was conduced on a se of firms lised on he NYSE, ASE and OTC: 221 in 1978, 248 in 1982 and 191 in ) Derivaion of he relaionship beween P/E muliple and leverage is aken by Schreiner (2007) from Koller, T. M., Goedhar, M., Wessels, D., Valuaion: Measuring and Managing he Value of Companies", Wiley & Sons, Hoboken, New Jersey, ) Coenenberg, A.G., Schulze, W., The Muliplikaor-procedure in he Unernehmensbewerung: Konzepionen und Kriik, Finanz Berieb, 12, ) Damodaran (2006) and Suozzo, P., Cooper, S., Suherland, G., Deng, Z., Valuaion muliples: A Primer, UBS Invesmen Bank, ) Evidence ha suppors his hypohesis has been also found by Alford (1992) and Liu, Nissim and Thomas (2002). 15) The auhors define he marke-o-book value as he raio beween he marke value of oal asses and he book value of oal asses. The marke value of oal asses is equal o (Price x Number of shares ousanding) + Shor-erm deb + Long-erm deb + Preferred shares - Deferred ax. 16) Anoher equivalen of P/B muliple a he eniy level, which appears in he classificaion presened by Schreiner (2007), is he muliple EV/TA (Enerprise Value / Toal Asses), where EV is equal o he sum of marke value common shares and he carrying value of ne deb. Ne debs are aken ino accoun equal o he carrying value of oal deb minus cash and equivalens plus he value of preferred shares.

8 110 Dragoş MÎNJINĂ 17) Myers, S.C., Deerminans of corporae borrowing, Journal of Financial Economics, 5, ) Baker, M., Wurgler, J., Marke iming and capial srucure, Journal of Finance, 57, ) Welch, I., Capial srucure and sock reurns, Journal of Poliical Economy, 112, ) operaing profi before depreciaion increased from 11.28% for he group wih he low marke-obook value raio o 15.21% for he group wih high marke-o-book value raio. 21) Chen and Zhao (2006) shows ha he credi spread (difference beween corporae bonds yields and hose of U.S. Treasury bonds wih similar mauriy), as a measure of corporae borrowing coss beyond he Treasury risk-free raes, are in a significan negaive relaionship wih marke-o-book value raio.