Business Valuation using Multiples

Business Valuation using Multiples - Methods of adjusting multiples taken from a developed economy: case study Romania - Author: BOGDAN CHIRIAC Coord...
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Business Valuation using Multiples - Methods of adjusting multiples taken from a developed economy: case study Romania -

Author: BOGDAN CHIRIAC Coordinator: Prof.univ.PhD. ANAMARIA CIOBANU There was a double motivation in choosing this subject. Firstly, a scientific one, professional, generated by the difficulty met when choosing a multiple for equity valuation. To this we add the attempt of determining the necessary corrections when taking a multiple from a developed economy, this action being hardened by the lack of information and comparables on the national market. Secondly, there was also a subjective motivation- the desire to research an area of personal interest, in which I wish to perfect, currently following a career in this area. Starting from these considerations, we have established the following objectives:  Determining, for Romania, at the beginning of 2012, what adjustments need to be made to multiples taken from a developed economy, specifically the U.S one  Computing synthetic multiples for Romania: Price earning ratio (PER), Price to sale (P/S) and Price to book value (P/B)  Establishing the necessary corrections in the case of industry belonging The purpose of this paper is to create a framework through which a valuator can, at any moment, determine the necessary adjustments for a multiple taken from a developed market. Based on the objectives stated above, we have structured this paper in three chapters. The first part, intitled Specialized studies, we discuss the literature and the empiric studies related to the topic at hand.  

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The relative valuation of a company assumes following some stepts: choosing the comparable peers and selecting valuation relevant multiples. However there are three considerations that should be taken into account regarding comparable firms in an emergent economy:1: a. The size of the sample b. Any differences between companies c. Liquidity issues When dealing with companies in an emergent market, finding comparables is difficult because of few transactions with similar firms. According to Anghel Ion2, the lack of information and transactions forces analysts from these countries to use a developed country as reference (like the U.S one). However, borrowing multiples from a developed country without correcting them for country risc is an irelevant action. The need for adjusting these multiples is obvious and sustained by empiric studies. Nonetheless, this method has its difficulties such as what multiple to choose, the time frame for which the correction coefficient should be determined, determining the correction coefficient. Pereiro also claims the multiples’ adjusment for emergent market liquidity. The first economists who researched relative valuation focused on PER, as Beaver and Morse did in 1978. They tried to determine the behavior of PER. Boatsman and Baskin (1981) determine the accuracy of PER based on two sets of comparables from the same industry. Alford (1992) states that selecting comparable firms based on industry membership is efficient. However, selecting comparables regarding on risk and earnings growth, used together has the same efficency. In a general study, Kaplan and Ruback (1995) compared the valuation performance of DCF against relative valuation. They concluded that both DCF valuation and EBITDA multiple based valuation supply the same exact estimations.

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A. Damodaran, Volatility Rules: Valuing Emerging market companies, pe http://pages.stern.nyu.edu/~adamodar/pdfiles/DSV2/Ch16.pdf, Stern School of Business, 2009, 2 Anghel, Ion; Stan, Sorin V., Evaluarea întreprinderii, Editura IROVAL, Bucureşti, 2007

 

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Nissim and Thomas (2001) show that multiples based on forward earnings (forward earning multiples) supply more accurate valuation than hystory based multiples. The same conclusions are drawn by Kim and Ritter (1999) and Lie and Lie (2002). Yoo (2006) shows that the P/S multiple has the weakest accuracy in valuation. The second component in estimating market value represents the identification of similar companies. This is a rather difficult task as two companies cannot be identical and firms from the same industry can differ. There are several factors that should be taken intro account when selecting peer companies, like: the size of the company, growth rate, firm risk, capital structure, size, industry, transaction date, amount of capital traded. Dragoş Ioan Mînjină (2007) claims that on the Romanian capital market, one selection criteria for comparables that can lead to better valuation accuracy is the return on equity (ROE)3. The second part, Theoretical foundation, captures the theoretical methodology of multiples and of comparable’s selection. There are two parts of relative valuation4. Firstly, when valuating assets, their prices need to be standardized. This is usually done by converting prices into multiples. Secondly, one must find similar companies, which is a rather difficult task. Under these circumstances, the question of how the differences between firms can be dealt with becomes a key one. Steps in applying market valuation (relative)5: Step 1: indentifying similar transactions of comparable companies, undertaken in the same conditions with those defining the company under valuation Step 2: analyzing relevant financial indicators in order to determine the financial situation of the peers. These indicators oftenly are: gross and net profit, cash flow, sales, assets, EBITA, etc.

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Dragoş Ioan Mînjină, Evaluarea prin multipli a acţiunilor de pe piaţa de capital din România, REPEC, 2009 4 Op. cit 5 Dalina Dumitrescu, Victor Dragotă, Anamaria Ciobanu, Evaluarea întreprinderilor, Ediţia 2-a, Editura Economică, 2002, p. 163

 

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Step 3: selecting the relevant multiple. It’s adequate to compute a mean or median of the prices investors are willing to pay for the comparable firms. Thus a price for the valuated company will be obtained6. Step 4: Valuation Multiples can be divided intro capital multiples (PER, PERg, PBV, P/S, P/CF gestiune, P/Asset) or intro company multiples (Firm value/EBITDA, FV/CF, FV/S). The third and last part, Methods of adjusting multiples taken from a developed economy : case for Romania, has a pronounced applicative nature. It’s a study case of the Romanian economy that tries to determine both the necessary adjustments for country risk but also the adjustments for industry belonging. We used three approaches: sovereign bond yield, market multiples ratio and multiple regression. Our analysis is based on a sample of data gathered from Bucharest Stock Exchange website and from the NYSE one. We selected companies listed both on NASDAQ and RASDAQ, these sample being used exclusivelly in the second part of the study. The initial sample was made up of 4973 companies. From which 73 were Romanian companies and 4900 U.S companies. We also used Yahoo Finance and Markettroler to complete our data. This first sample was then adjusted, and based on the analysis performed, certain companies were excluded. This paper addresses the problem of building a methodology for adjusment taking intro account country risk and industry risk. In order to to so, we analysed two markets: the Romanian one as an emergent market and the U.S one as a developed market. The analysis was carried as at february 2012. Using the yield to maturity bond spread the correction coefficient of a U.S based multiple should be 34.8%. The second approach supports the construction of a correction coefficient using the multiples’ median of the emergent and developed economy. This method describes the relative difference between investors’ perceptions from the two markets and                                                              6

Simon Z. Benninga, Oded H. Sarig, Corporate Finance: A valuation Approach, McGraw- Hill, New York, 1997

 

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illustrates the difference for country risk (companies from a stable market should have higher value multiples). This ratio incorporates other firm specific risks like corporate governance differences7. This reason is why such an approach should offer better results than the previous one. Multiples’ adjusments: PER Adjusment/correction

57.43%

P/B

P/S

31.76%

32.10%

The above mentioned adjusments are derived from a practical experience. However they can be subject to theoretic criticism. This is why we will do regression analysis which will show what adjusments are necessary. PER = 14.86 + 4.19 Payout Ratio8 - 0.93 Beta + 7.61 D_Country risk , R2=5.7% PER = 17.3 + 4.3 Payout ratio – 0.717 Beta + 7.24 D_Country risk –5.04D22.08D3- 2.69D4 + 0.07D5 - 3.35D6- 2.1D7, R2= 6.6% P/S = 0.43+ 0.074Marja Operaţională +

0.044NI/Sales

-0.38Beta+ 1.02

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D_Country risk, R =46.3% P/S = 0.51 + 0.07Marja Operaţională + 0.044NI/Sales – 0.33Beta – 0.295D2 0.72D3 - 0.21D4 - 0.20D5 - 0.69D6 -0.54D7 + 0.9 D_Country risk, R2=47% P/B = 1.19 - 0.12Beta - 0.0001Payout + 0.0001ROE + 1.81 D_Country risk 0.12D2 + 0.54D3 - 1.44D4 + 0.21D5 - 0.34D6 + 0.34D7, R2=7.5% P/B = 0.79 + 1.77 D_Country risk The results obtained sustain the necessity of adjusting multiples taken from a developed country both for country risk and for industry difference. In this paper we have used several research methods: econometric analysis, synthesis, comparison and study case. We have also considered it necessary to have a number of 16 annexes that complete and justify the results found in our paper. We consider that this topic is a complex and up-to-date one.                                                              7 8

 

Pereiro, Luis, Valuing Companies in Emerging Markets, Editura Wiley Finance, New York, 2002 Written as 0.0X

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Relative valuation can be done with fewer initial hypotisys and faster that through any other valuation method; it is simpler to understand and easier to show to clients than other valuation techniques; it’s more probable to reflect the market’s current state because it’s an attempt of measuring a relative value and not an intrinsic one. Moreover, multiples derive from spot prices which reflect several inverstors’ expectations and not only one’s. Market multiples ratio leads us to adjusments of 57% (for PER), 31.7% (for P/B) and 32% (for P/S). At this stage we introduced sector difference and we computed adjusments for the three multiples based on industry belonging. This corrections were calculated as stated before (median’s ratio). Finally, we ran a series of regressions in which we introduced dummy variables to quantify country and industry risk. The results were obvious, the necessity of adjusting multiples was sustained by the validity of the econometric models. Based on the data as at april 2012, we can state that for PER, the multiple should be adjusted, if taken from the U.S with approximately 50.8%. For Romania it should be 14.92 and for the U.S 22.4. We consider that the paper can be used as a framework in determining the necessary adjusments of multiples taken from a developed economy. Moreover, the synthetic ecuations for P/S and P/B can be used in practice to compute these multiples. We must keep in mind that these ecuation are valid at a certain time, and as data change in market, these equation will suffer changes as well. This paper can also be used by multinational companies that have branches located within an emergent market. Because of globalization, more and more companies are turning towards emerging markets and thus, valuation in a comparable poor environment becomes something of the present. At a first glance, using multiples might seem an easy and direct method. Unfortunately, in practice, it is not as easy at is seems. Selecting multiples to truly reflect value and identifying a comparable group implies some problems.

 

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BIBLIOGRAPHY 1. Adams, Michael; Thornton, Barry, A comparison of alternative approaches to equitz valuation of privately held entrepreurial firms, , Journal of Finance and Accountancy, Jacksonville, 2009 2. Alford, Andrew W, The effect of the set of comparable firms on the accuracy of the priceearnings valuation method, Journal of Accounting Research, Vol. 30, 2002 3. Anghel, Ion; Stan, Sorin V.; Evaluarea întreprinderii, Editura ASE, Bucureşti, 2003 4. Benninga, Simon Z., Oded H. Sarig, Corporate Finance: A valuation Approach, McGraw- Hill, New York, 1997 5. Boatsman, James R./Baskin, Elba F., Asset valuation with incomplete markets, in: The Accounting Review, Vol. 56, No. 1, 1981 6. Ciobanu Anamaria, Dumitrescu

Dalina, Dragotă Victor, Evaluarea întreprinderilor,

Editura Economică , Bucureşti, 2002 7. Ciobanu, Anamaria; Victor, Dragotă, Management financiar, vol II, Editura Economică, Bucureşti, 2003 8. Damodaran, Aswath, Damodaran on Valuation: Second Edition, Editura Wiley Finance, New York, 2006 9. Damodaran, Aswath, Volatility Rules: Valuing Emerging market companies, Stern School of Business, 2009 10. Damodaran, Aswath, Valuation Approaches and Metrics: A Survey of the Theory and Evidence, Stern School of Business, November 2006 11. Dittmann Ingolf, Weiner Christian, Selecting Comparables for the valuation of European Firms, Humboldt University, Berlin, 2005 12. Fernandez, Pablo; Bilan,Andrada, 110 Common errors in company valuations, REPEC, Madrid, 2007 13. Fernandez, Pablo “Valuation Using Multiples. How do analysts reach their conclusions?”, University of Navarra, Barcelona, 2002 14. Herrmann Volker, Richter Franck, Pricing with Performance- Controlled Multiples, Schmalenbach Business Review, Vol. 55, Witten, 2003 15. Kuznetsov, Ivan, Multiples Valuation on Emerging Markets, Humboldt- University, Berlin, 2006 16. Lie E., Lie H. J, Multiples Used to Estimate Corporate Value, Financial Analysts Journal, Vol. 58, Numărul 2, (44-54), 2002

 

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17. Liu, Jing; Nissim, Doron; Thomas, Jacob, Equity valuation using multiples, Journal of Accounting Research, Vol. 40 18. Mînjină Dragoş Ioan, Relative Performance of Valuation Using Multiples. Empirical Evidence on Bucharest Stock Exchange, REPEC, Bucureşti, 2009 19. Pecican, Ş Eugen, Econometrie, Editura C.H. Beck, Bucureşti, 2007 20. Pereiro, Luis, Valuing Companies in Emerging Markets, Editura Wiley Finance, New York, 2002 21. Ramcharran H. , An empirical analysis of the determinants of the P/E ratio in emerging markets, Emerging Markets Review, Volumul 3, Numărul 2 (165-178), 2002 22. Sanjeev, Bhojraj; Lee, Charles M. C, Oler K. Derek, Who is my peer? A valuation-based approach to the selection of comparable firms, Journal of Accounting Research, 2002 http://www.peimedia.com www.bvb.ro http://finance.yahoo.com/ www.marketroller.ro http://econpapers.repec.org www.bnr.ro http://www.boerse-berlin.de/index.php http://www.boerse-frankfurt.de/en/start www.nyse.com www.investopedia.com

 

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