AN EXPERIMENT
Consider thefollowingexperiment.Youareanalyzing two
firms with thesame overall market risk exposure and the
same financial leverage. Assumethat both firms have the
sameoperating earningsand similar returnson capitaland
thatyouexpectthesamegrowthrateintheoperatingincome.
Finally,assumethatfirmAisafirminasinglebusinesswith
open and easy-to-understand financial statements whereas
firmB is a firmin multiple businesseswith complex and
difficult-to-decipher financial statements. Given that they
havethesamefinancialfundamentals,shouldtheytradeatthe
samevalue?Ifnot,whichofthesetwofirmsshouldbevalued
more highly and why?
In conventionaldiscounted cash flow(DCF) valuation, we
would attach the same value to both firms.
1 Afterall,theafter-taxcashflowforafirmcomesfromits
operatingincomeandreinvestmentneeds,andnoadjustments
aremadeforhowcomplexafirmisinthiscalculation.The
discountrateiscomputedbasedonthenondiversifiablerisk
intheequityofthefirmandthedefaultriskofitsdebt.Itis
true that the beta for a multibusiness company will be a
weightedaverageofthebetasofthedifferentbusinessesitis
in,butthatdoesnotpenalizeadiversifiedfirm.Infact,we
often give diversified (and complicated) firms a slight
advantage in discounted cash flow valuations by allowing
them to carry more debt and have lower costs of capital.
Inrelativevaluation,weareevenmorehaphazardabouthow
we deal with complexity. We compare firms on
price-earnings (P/E) ratios or enterprise value to EBITDA
(EV/EBITDA) multiples, and even if we adjust for