Valuation Multiples: What They Miss, Why They Differ, and the Link to Fundamentals

Apr 23, 2024

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Most investors “price” the stocks of companies by using valuation multiples instead of “valuing” them based on future cash flows and fundamentals.
This report addresses what valuation multiples miss and why they have become less informative.
We examine how the two most popular multiples, P/E and EV/EBITDA, can provide different signals about a stock’s relative attractiveness.
We look at alternative measures of earnings and EBITDA and then take a deep look at the EV/EBITDA multiple.
We do not discourage the use of multiples, but we encourage those who use them to understand the underlying value drivers.

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DEFINITIONS
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

Enterprise value (EV) measures the market value of a company. It is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

Enterprise value to earnings before deduction of interest, tax and amortization (EV/EBITDA) compares the value of a business, free of debt, to earnings before interest.

Free cash flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able generate after laying out the money required to maintain or expand its asset base.

Price-Earnings (P/E) is the price of a stock divided by its earnings per share for the past 12 months. Sometimes called the multiple, P/E gives investors an idea of how much they are paying for a company’s earning power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

IMPORTANT INFORMATION
The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

This material is for the benefit of persons whom the Firm reasonably believes it is permitted to communicate to and should not be forwarded to any other person without the consent of the Firm. It is not addressed to any other person and may not be used by them for any purpose whatsoever. It is the responsibility of every person reading this material to fully observe the laws of any relevant country, including obtaining any governmental or other consent which may be required or observing any other formality which needs to be observed in that country.

This material is a general communication, which is not impartial, is for informational and educational purposes only, not a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. Information does not address financial objectives, situation or specific needs of individual investors.

Any charts and graphs provided are for illustrative purposes only. Any performance quoted represents past performance. Past performance does not guarantee future results. All investments involve risks, including the possible loss of principal.

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