Introduction to Corporate Finance

5: Valuing Shares

course, no two companies are exactly alike, but an analyst using this approach attempts to gather a large

number of companies that are as much alike as possible.

Second, for each company in the sample, divide the company’s value (either its total value or its

value per share) by some measure of operating performance to get a ‘pricing multiple’. For example,

one common multiple is the price/earnings (P/E) ratio introduced in Chapter 2, where value per share

is divided by the performance metric earnings per share. Other multiples frequently used by analysts

include the ratio of the market value of a company’s equity to its book value (the price-to-book ratio), and

the ratio of company value (Vcompany) to earnings before interest, taxes and depreciation and amortisation

(EBITDA).

Third, take the average or median pricing multiple from your sample of comparable companies, and

multiply that by the operating variable (such as earnings) for the company you want to value.

The intuition for this approach is relatively straightforward. Simply stated, the multiples method

says that similar companies should sell at similar prices relative to their operating results, where

operating results are often measured by sales revenue, earnings or cash flows. For example, consider

two companies, which we will call Twilight and Potter. Both of these companies operate in the

book publishing business, so their operating risks should be similar, which means that investors

should expect about the same return from each company (we’ll assume the required return is 10%).

Likewise, let’s assume that both companies have been growing at a steady 5% per year in the recent

past. For simplicity, we will also assume that neither company has any debt financing or preferred

shares.

One big difference between the two companies is that Potter generates substantially more free

cash flow than Twilight. In fact, investors believe that next year, Potter will generate $2.0 billion in

free cash flow, and Twilight will deliver $1.0 billion. Let’s value each company by discounting its free

cash flows.

Robert Shiller, Yale

University, Nobel Prize

winner in Economic

Sciences.

‘When the P/E ratio

is high, it’s typically

justified by an argument

that earnings will go up

in the future.’

See the entire interview on

the CourseMate website.

CoURSEMAtE

SMARt VIdEo

HOW INVESTMENT BANKERS VALUE COMPANIES

When one company attempts to acquire another,

both the bidder and the target company may hire

an investment banker to provide fairness opinions,

written reports that provide the banker’s expert

opinion regarding the fairness of the price offered

by the bidder. Matt Cain and David Denis have

investigated which methods bankers use in their

fairness opinions to value target companies. As

the authors show, bankers almost always perform

a discounted cash flow valuation as part of their

analysis; but they sometimes use other methods.

In a slight majority of acquisitions, bankers value

the target company by using comparisons to

public-company multiples such as P/E ratios.

Public-company multiples are an example of

valuation using the market multiples of comparable

companies, which we discussed in Section 5-4b.

Bankers also use transaction multiples (price paid

relative to target earnings in recent acquisitions)

and transaction premia (what bidders have paid for

targets, above and beyond their market values, in

recent deals) when advising their clients.

finance in practice

Source: Matt Cain and David Denis, ‘Information Production by Investment Banks: Evidence from Fairness Opinions Working paper’, May 2012.

Why might an investor want to

use more than one method for

valuing a target company in a

takeover bid?

thinking cap

question