Investment Banking For Dummies

Investment Banking for Dummies PDF Investment Bankers talk a lot about multiples. In fact, almost everyone in finance talks about multiples. 

What the heck is a multiple anyway? Multiples reflect the market’s perceptions of a company’s growth prospects, so two companies with similar prospects and operating characteristics should trade at similar multiples.

If one is trading at a lower multiple than its “comparable” peers, then we can surmise that it is undervalued in the market. But is that all there really is to it? Why do multiples reflect a company’s growth prospects – and is that the only thing they reflect? What really underlies a multiple? What does it really mean to say that Microsoft (MSFT) trades at a 23.0x Share Price/EPS [P/E] multiple, or that Google (GOOG) trades at a 12.0x EV/EBITDA multiple?

How do you value a company?

Before we look under the hood of a multiple, let’s take a step back. A common investment banking interview question goes as follows: “How do you value a company?” To which, the prospective analyst or associate will be expected to respond that there are two major approaches – one is an intrinsic valuation – to calculate the present value of expected future free cash flows. The other approach – relative valuation – involves merely looking at the market values of comparable companies and applying those values to the company under analysis.

The distinction seems stark- the intrinsic approach suggests that the value of a hot dog stand should fundamentally equal the present value of the cash flows it is expected to generate in the future, while the relative approach suggests that the value of the hot dog stand can be derived by looking at the value of comparable hot dog stands [perhaps one was sold recently and the purchase price is observable].

Multiples in valuation

Multiples play a central role in relative valuation. In our hot dog stand example, suppose a comparable hot dog stand, Joe’s Dogs, was purchased for $1 million several months prior to our hot dog stand being valued today.

If we know that Joe’s Dogs generated EBITDA of $100,000 in the last twelve months [LTM] prior to acquisition [that’s an Enterprise Value / EBITDA multiple of 10.0x], and we know that our hot dog stand generated LTM EBITDA of $400,000, we can apply the recently acquired EV/EBITDA multiple to our company, and estimate that we should expect a value of somewhere around $4.0 million for our hot dog stand today.

Whew! You can see how that’s a lot easier than projecting out cash flows each year and calculating a present value. That’s why multiples analysis is ubiquitous in our world. While investment bankers use multiples all the time – in comparable company analysis, comparable transaction analysis, in LBO valuation, and even, for better or worse, in DCF valuation – there is often confusion about what these multiples actually represent.

But are these valuation methods really distinct? If your gut tells you that there has to be some connection, you’re right. But how do we reconcile valuing companies intrinsically with valuing companies based on multiples?

Cash is king

Intrinsic valuation says the value of a business is a function of the free cash flows [see definition below] that it can generate, plain and simple. Say you are considering buying a business that will generate $1,000 in cash every year forever. Based on your calculation of the riskiness of the business, you require an annual return of 10%. As such you calculate that the most you would be willing to pay for such a business is:

$1000
-------- = $10,000
(.10)

Expanding the discussion slightly, if you expect the business’s free cash flows to grow by 5% every year, the calculation would change slightly to:

$1000
--------- = $50,000
(10%-5%)

In fact, the general perpetual growth formula can be expressed as:

Value= Free cash flow
--------------------------
Discount rate [r] – growth [g]

We can delve a little deeper into this formula by breaking down free cash flows and growth into their component parts:

Free cash flows = NOPLAT [Net Operating Profit / Loss After Taxes] – Net Investment
Net Investment = Working Capital Investments + Capex + Intangible Asset – D&A
Growth rate = Return on invested capital [ROIC] * Investment rate
Investment rate = Net Investment / NOPLAT

Rearranging our value equation, we arrive at:

Value= NOPLAT (1-g/ROIC)
-------------------------------
Discount rate [r] – growth [g]

So where do multiples come in? Well, let’s take a common multiple: EV/EBIT. How does the EV/EBIT multiple fit into our understanding of value?

First let’s define EBIT relative to cash flow. Assuming you are the sole investor in the business for now [i.e., no debt] NOPLAT and, consequently, free cash flows, can be restated as:

NOPLAT = EBIT * [1-tax rate[t]], such that free cash flow = EBIT x [1-t] [1+g/ROIC]

Dividing both sides of our value equation by EBIT, we arrive at the definition of the EV/EBIT multiple:

Value = (1-t)(1-g/ROIC)
--------- -------------------------
EBIT (r-g)

Voila! All of the sudden, the drivers of a multiple become quite clear:

• r: the higher the required return of a business, the lower the multiple
• g: the higher the growth of a business, the higher the multiple
• t: the higher the taxes on a business, the lower the multiple
• ROIC: As long as ROIC is greater than the opportunity cost of capital (r), the higher the ROIC of a business, the higher the multiple.

Conclusion: 

So there you have it. Multiples are simply a way to discuss value. When you compare one company’s multiple to another company’s multiple, if all the value drivers are equivalent [discount rate, growth rate, ROIC, tax rate], then the multiples should equal.

However, if one or more of the drivers are different – say company A’s growth rate is higher than company B’s, then company A’s multiple should be higher. If it is not, then you can say that company B is overvalued relative to company A.

If company A’s multiple is appropriately higher than company B’s, you can say that company A trades at a premium to company B to reflect higher long-term growth. While tax rates and discount rates are generally equivalent across firms in similar industries, ROIC and growth rates can be quite different, so in fairly-priced equity markets, companies with higher multiples within a particular industry generally reflect different assumptions about ROIC, growth, or a combination of both.

The Benefits and Challenges of Short Term Trading

Short term trading refers to any trading strategy, in the stock or futures markets, where the duration between trade entry and exit ranges between a few days and a few weeks. Although this form of trading can be very lucrative, it is also very risky. Therefore, in order to be successful when trading in this term length, you must understand the benefits and challenges of what you're doing. Knowing how to spot good trading opportunities isn't enough: You must also learn how to protect yourself from unforeseen events.

One of the main benefits of short term swing trading is the fact that your capital is only at risk for short periods of time. Therefore, if you make the wrong decision on a trade, you will know it within a few days or weeks. This gives you the opportunity to free up your capital for new, high quality opportunities. In addition to the short period of risk, trading in the near term has lower capital requirements than long term trading which often requires a sizable amount of capital.

When trading like this, the expected risk/reward profile of a trade can easily be determined. This is because in swing trading, the profit targets and the risk are both well defined. With such clarity and consistency, it is easy to plan where you will exit the trade and the maximum amount of time you plan to spend in the trade. Last among the benefits, is the ability to use "bracket orders," which enable you to place entry orders, stop losses and profit-taking limit orders simultaneously?

Short term trading is not without its disadvantages. To begin with, trading in the short term is expensive. This is due to the high trading costs which are brought about by the short holding period and the frequent trade entries and exits. In addition, risk management in short term swing trading can be quite challenging. Holding a position over a longer period of time is in itself a risk management and loss-limiting strategy. However, since as a short term trader you do not have the option of holding a position for a long period of time, you must learn to use momentum and volatility to your advantage.

Despite the above mentioned challenges, short term trading can be very beneficial to a portfolio especially when it is combined with long term trading. Diversification of portfolios enables traders to improve their overall risk/reward balances.

By Jeremy B Thompson