Reading analytical reviews, we meet such acronyms as P/E, EBITDA, ROE, etc. It sounds mysterious, but not everything is as complicated as it may seem at first sight. Let’s deal with it.
These indicators refer to the fundamental analysis, more precisely to comparative assessment. It is accepted to consider this estimation as “fast”, it is capable to give instant, though less exact picture of reality in comparison with complex models of discounting of cash flows: to show how much stocks are underestimated or overestimated in comparison with competitors.
What are market multipliers?
Imagine this situation. You compare two public enterprises. They have a similar business, capitalization and financial performance, but a different number of shares. As a result, the price of one share in two cases can be noticeably different. Does it mean that one paper is really cheaper or better/attractive than the other? Not really.
To get a more objective picture, it is necessary to bring two companies to the same denominator. More precisely, to compare the value of the company with its financial indicators, such as income. This approach will make it possible to get rid of the effect of a different number of shares in circulation, making it possible to find real discrepancies in asset pricing.
This is a comparative assessment or assessment by multipliers. By market multiples it is accepted to understand the ratio of enterprise value and its income, cash flows, book value, etc.. As a result, we have profit or, for example, revenue per share, regardless of the size of the company or the number of securities in circulation.
Formally, a lower multiplier compared to analogues shows that shares are undervalued and even “cheap”, and vice versa. Let us consider the main types of comparative coefficients.
Economic multipliers are divided into four main groups:
- income multipliers – correlate the income received by the company to other indicators, revealing its share;
The best known in this group is the P/E (Price per Earnings) multiplier, meaning the ratio of the company’s value (capitalization P) to its net profit (Earnings E). It shows how many years a company, earning similar profit, can recoup its current market value of equity capital.
- Profitability multipliers – describe the overall economic efficiency and profitability of the company;
The main among them – ROE (Return On Equity) – shows the profitability of equity capital and is the ratio of net profit to equity capital of the company. The multiplier shows how the company is able to generate profit from its own funds. To calculate the equity capital you should refer to the balance sheet.
- Financial stability multipliers – shows the degree of creditworthiness of the company and its ability to service its debts;
First of all, in this group of multipliers calculate the leverage ratio, which is equal to the result of dividing the total debt of the company by the size of its assets. The multiplier shows what part of the company is formed from borrowed funds.
The most stable companies are those with a leverage ratio of less than 0.5, i.e., those formed with less than half of their assets.
- Solvency multiples – shows the ability of a company to pay its debts with both cash and sale of assets.
The most known indicator of this group is the coverage multiplier, which shows the ratio of current assets with the term of sale of 12 months to short-term debts to be paid within the next 12 months. The ratio shows the ability of the company to pay for the nearest payments from the maximum liquid assets.
Good indicators in this case are between 1.5 and 2.5. If the ratio is below 1, it indicates the inability of the company to pay its short-term debt with the maximum liquid assets.
For construction of multipliers the data of financial reports of the company for some years are taken – better than annual, as quarterly can be too volatile – and are compared with similar indicators of companies in the industry to identify the dynamics.
Computation of financial multipliers helps to compare companies with each other, providing uniform information suitable for comparison. Firms within an industry are typically compared, but cross-sector comparisons are sometimes acceptable.
With a proper approach, benchmarking can be extremely useful for an investor. It is not necessary to count the indicators yourself, but it will be much easier to understand the analytical notes. It should be understood that this is only one of the methods complementing other directions of fundamental analysis, as well as technical analysis.