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April 23, 2024

Valuation Multiples: What They Miss, Why They Differ, and the Link to Fundamentals

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April 23, 2024

Valuation Multiples: What They Miss, Why They Differ, and the Link to Fundamentals


Consilient Observer

Valuation Multiples: What They Miss, Why They Differ, and the Link to Fundamentals

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April 23, 2024

 
 
  • Most investors “price” the stocks of companies by using valuation multiples instead of “valuing” them based on future cash flows and fundamentals.
  • This report addresses what valuation multiples miss and why they have become less informative.
  • We examine how the two most popular multiples, P/E and EV/EBITDA, can provide different signals about a stock’s relative attractiveness.
  • We look at alternative measures of earnings and EBITDA and then take a deep look at the EV/EBITDA multiple.
  • We do not discourage the use of multiples, but we encourage those who use them to understand the underlying value drivers.
 
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DEFINITIONS
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

Enterprise value (EV) measures the market value of a company. It is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

Enterprise value to earnings before deduction of interest, tax and amortization (EV/EBITDA) compares the value of a business, free of debt, to earnings before interest.

Free cash flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able generate after laying out the money required to maintain or expand its asset base.

Price-Earnings (P/E) is the price of a stock divided by its earnings per share for the past 12 months. Sometimes called the multiple, P/E gives investors an idea of how much they are paying for a company’s earning power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

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