Valuation Multiples, Growth Rates, and Margins

hello and welcome to another tutorial lesson this time around we're going to be addressing once again a really good question that came in to our helpdesk system the other day this one is related to valuation multiples and here's the question I'm confused about how to interpret valuation multiples if one company's enterprise value to EBIT on multiple is higher than another's does that mean that it is growing more quickly or does that just mean that it's EBIT on margins are higher in other words are multiples more strongly correlated with growth rates or with margins so this seems like a very very simple question but it's actually quite difficult to answer concisely because it depends on a couple factors first off it depends on which multiple we're talking about second it depends on which growth rate we're talking about and third it depends on which margin you're referring to so as an example let's say that we want to look at a set of biotech or pharmaceutical companies and I have an example here on screen for jazz Pharmaceuticals one of the companies we cover in our case studies if we were to ask a question like this first off we'd have to say are we talking about revenue growth or Ebay da growth are we talking about the emo Dom margin or the EBIT margin or the free cash flow margin and then which multiples are we talking about because we might expect that the revenue multiples are going to be closely linked to revenue growth maybe and that perhaps the e Badal multiples will be linked to margins or Ebay da growth or something like that but what about revenue growth is that related to the IBAs on multiple and is the e bizarre growth related to the revenue multiple so you have to be very very specific about what you're asking for in this question the short answer though is that valuation multiples are generally correlated with growth rates because valuation multiples are shorthand for a full DCF analysis of a company in a set of similar companies that you are analyzing what this means is that if a company's free cash flow is growing at a higher rate is growing at a faster clip then all else being equal that company should be valued at a higher multiple than companies that are not growing as quickly or companies that are not expected to grow as quickly so in this tutorial I'm going to explain three main things first off I'm going to show you why multiples are shorthand for a full DCF analysis second I'm going to look at this in real life and see how well this correlation actually holds up third I'm going to show you why in many cases even though according to finance theory this is true the real-life correlation is sometimes questionable or not really there at all and then we'll do a recap in summary at the end so let's start with point number one why multiples are shorthand for a DCF analysis to start with remember the formula for terminal value in a DCF I'll bring up an excel file here with a simple DCF analysis you can calculate terminal value in a couple different ways but if you use the long term growth or perpetuity growth method essentially you're taking the company's final year free cash flow which we have the bottom here and then you're multiplying by one plus the terminal growth rate and you're dividing by the discount rate minus the terminal growth rate so this is what the formula looks like written out in words here and so the implication of this formula is that if you have a higher terminal value it's because either the free cash flow grow through it was higher or because the discount rate was lower and to show you an example firsthand let's say here that I changed the growth rate to five percent rather than two point seven percent well now our terminal value goes up and our implied multiple it goes up in other words when we take that terminal value and divide it by the company's EBIT on its final year that multiple is now higher the terminal value itself is now higher because we have a higher growth rate now on the flip side if we're over here and we reduce the discount rate to say 8% now are implied multiple is also higher and our terminal value is also higher so you can just look at the formula and tell that's how it works if you have a lower terminal value it's because you have a lower free cash flow growth rate or a higher discount rate or possibly both them at once so those are the variables that impact a company's implied value from a DCF which in large part really comes from the present value of the terminal value so the obvious question at this point now is clearly if a company's free cash flows are growing at a higher or lower rate that might be able to explain a higher or lower EBIT on multiple for the reason that we just showed but what about the discount rate how do we know for example in a set of comparable companies that one company isn't just trading at a higher or lower multiple simply because it's discount rate is lower or higher for example the answer is that typically in a set of comparables you pretty much assume that the discount rate for all the companies there is about the same simply because of the way that you pick the companies in that set I'm going to illustrate with another example going back to the biotech pharmaceutical industry here in this case study for Jazz pharmaceuticals we picked specialty pharmaceutical companies with revenue between 500 million and 2 billion and this is what our set looked like when we want to calculate the cost of equity and whack for example to get to the discount rate now if we were to go in and do this I just have what it looks like for jazz on screen but if we were to look at these other companies and use the same set of comparables for these other companies we would get to a very very similar result because they're all in the same industry they're all in roughly the same size range they even have very very similar capital structures so if you think about that what it means is that if these companies are in the same industry and they have similar financial profiles similar financial criteria then the risk return profile is probably going to be pretty similar among all these so the discount rate should be similar as well and so when you're looking at a set of compare balls like this the implicit assumption usually is that the discount rate is very very similar if not the same simply because the screening criteria is so similar and investors expect similar things by investing in the sector so if the discount rate is the same or at least similar for a set of comparable companies that creates a few implications what it really means now is that generally speaking a higher terminal value and therefore a higher multiple really means that the company's free cash flow growth rate has to be higher to justify it at least if as we're doing here we're taking one company jaz pharmaceuticals comparing it to many similar companies in its industry on the other hand if the terminal value in the multiple therefore are lower then that means that usually the free cash flow growth rate has to be lower to explain that so now the question becomes if it's really the free cash flow growth rate and not the discount rate so much that's determining a company's multiple or applied multiple what determines that free cash flow growth rate and to answer this let's go back to our DCF this simplified example for a manufacturing company but we'll just keep going with this if you look at everything that goes into the free cash flow formula down here let's just take a look so we have our net operating profit after taxes we have non-cash adjustments we have the net change in working capital and then we have capital expenditures so in short we get our revenue we have some type of margin on that revenue we pay taxes on it and then we make non-cash adjustments we have working capital and capital expenditure requirements and that gets us to free cash flow so in theory any of these items could impact the free cash flow growth right here but in practice as you probably guessed the major drivers are really revenue growth and the company's operating margin or EBIT Dom margin they're expressing similar ideas it just comes down to how you want to set up your model here - which one you use so in other words if the company's revenue is growing at a much faster clip and its margin state in about the same range then it's free cash flow is also going to be growing at a faster clip and then if it's revenue growth stays at what it's at right now but then it's margins are increasing by a lot more then it's free cash flow is also going to grow at a faster rate so if you think about it what it really means here is that taken together a company's revenue growth and operating margin effectively determine how quickly their operating income or ebody are grown and to see an example of this I have up here or set up a frame I have up here this analysis and if you go and take a look at this so I have their revenue growth rate their operating margin and then their operating income growth so in year one we have five percent and around five point two percent and then about four point one percent operating income growth and then after that our operating margin goes up our revenue growth goes down but our operating income growth goes up and then in subsequent periods our operating margin keeps increasing our revenue growth keeps decreasing but those two factors together determine our operating income growth right here and so all seeing equal this and the EBIT a growth which we have here at the bottom should factor in strongly to the companies on leverage free cash the growth rate now if you look at the actual numbers here at the bottom you can see that this doesn't exactly hold up there is some small differential but it's a pretty good trend overall in most of these years the EBIT our growth rate and the free cash flow growth rate are quite similar and toward the end they effectively become pretty much the same if not close to the same so going back to what I was just saying if margins are staying in the same range then operating income or EBIT growth are going to move in line with revenue growth if revenue is growing more quickly and you're staying at a 20 percent or 10 set margin then all of that revenue growth is going to flow down into eBay da or operating income growth and to see an illustration of this let's go back up here and let's just keep our margins at exactly the same as what they were like historically if we do this you can see exactly what happens our revenue growth over here 5% 4% 4% 4% eventually down to 1.5% is exactly the same as our operating income growth so our revenue growth just flows down directly because the margins are not changing at all it's going to change that back for now so if the margins are staying the same then this is really going to move in line with revenue growth on the other hand if margins are not staying the same then all bets are off if margins are increasing then the free cash flow growth rate is going to exceed the revenue growth rate as is the case here because look at this our revenue growth is actually falling but since our operating margins are increasing our operating income growth is fluctuating sometimes going up sometimes going down eventually it's mostly going down here but you can see how those increasing margins definitely threw things off by a bit and you can also see how in years when the margin see is the same effectively this is just trending with revenue growth over here so really the key point from all this is that it's not about the margins themselves it's about how those margins are changing and how those changes impact operating income or EBIT ah growth so for example if you have a 40% epiderm margin company and a 20% padam margin company if they're both growing EBIT ah and free cash flow at the same rate and they're in the same industry they're about the same size the valuation multiples such as the EBIT on multiple should be very similar for these companies yes one of them has a much higher margin than the other but this doesn't really matter because going back to the formula for terminal value in a DCF and the implied multiple the margin doesn't factor into this formula at all all that matters is how quickly they are growing that free cash flow and that is why generally growth is going to be much more strongly correlating to this than margins if you have a case where the company's margins are changing by a huge amount then okay sure you're going to see more of an impact from margins in that case but in most cases you generally assume that margins say in about the same range for most mature companies so that's why growth plays such an outsized role in determining a company's implied value and its valuation multiples and I just summarize what I said here that the terminal value formula doesn't factor in margins at all so it's really all about the growth rate so that's the theory behind us and now the question is does this actually hold up in real life does it work in real life or is this just a matter of Finance Theory to take a look at this we're going to go back to that set of pharmaceutical companies and I'll set up a frame once again so you can see everything so we have these companies projected ebody growths from year 1 into year 2 right here and what I've done is I also have down here they're either top multiples over the same time frame it's a little bit hard to see on screen but essentially what we can do here is look at each of these companies and look at their EBIT on multiples for 2015 and then compare them to their projected EBIT growth for the same year at the time we did this case study 2015 was still a projected year so we can look at these and see just how much of a correlation there is so we have one company growing at 10% with a 7x multiple another one at 14% with a 21 X multiple so so far there appears to be a pretty strong correlation and then we have a company at 22% growth with a 23 X multiple so it's a bit uneven but there still appears to be some correlation here but then we have another company the one we're valuing actually with 36% epithet growth and only an 11x multiple and then we have this one company with 41% growth and a 10x multiple and then we have a company with 137 percent growth and only a 9x multiple so the overall conclusion from looking at all these and line them up is that there isn't really a particularly strong correlation here if there even is a correlation at all so you might be asking yourself now why is this a case why does it not really hold up for this set of companies here the main reasons why it doesn't really hold up here first off acquisitions can greatly threw things off especially when it comes to the growth numbers if you look at some of these companies 136 percent growth doesn't really happen naturally not even in the pharmaceutical industry especially for companies that are early public and already have a good amount of revenue so this was almost certainly an acquisition that explained this a high growth rate and then for some of the others like Salix here we don't know for sure we'd have to go back and look but 40% growth combined with a fairly low multiple also generally points to an acquisition so acquisitions in in organic growth so in other words if a company was acquired and the deal is going to close in the next year and then the EBIT off from that acquired company is going to start flowing in next year those can definitely throw things here off by quite a bit another issue is that eBay and free cash flow are not necessarily close together and other items like capital expenditures can impact free cash flow so going back to our DCF analysis here let's just take a look at this and see how close together they are for this company so on lever free cash flows 235 EPA is closer to 600 million in this case they're actually very very very far apart there's a massive difference between them now the growth rates are similar in some years at least most years after this initial period but the actual numerical values are quite a bit different because capital expenditures is huge it factors into free cash flow but not into EBIT ah working capital is also significant factors into free cash flow but not EBIT ah and then you have taxes and other items that just do not show up in Eva da but which do affect free cash flow so that's another thing that throws this off another problem is that in a lot of industries valuation is not truly based on fundamentals and a lot of it gets very very speculative here so in this case for the pharmaceutical companies a lot of these companies will treat based on how investors and other stock market traders think that the results of clinical trials will go so if they think that the results from one drug that is currently being tested will be good then perhaps they'll bit up the company's price not based on any rational scientific information but just based on a hunch that one company's drugs will get through clinical trials and the other company's drugs will not so you see a lot of speculation and a lot of company's stock prices taking wild dives up and down in an industry like this it's not that it's completely detached from reality or fundamentals but there's probably less of a correlation than there is in say the manufacturing industry and then finally maybe the company just mispriced maybe the market got it wrong and the company is overvalued or undervalued in this example at the end of our analysis we conclude that jazz pharmaceuticals is significantly undervalued not just based on this but it is a contributing factor that even without huge acquisitions like some of these other companies it is growing at a faster clip than many of them but it's multiples are quite a bit lower or on the revenue side about the same maybe a little bit higher than some of the other companies and the median of the set so that's another possibility as well and it's up to you to decide which of these if any is playing a role and what they tell you about a company's true intrinsic value so now that we've reached the end of that let's do a quick recap and summary of this question if you recall the original question was our valuation multiples more strongly correlated with growth rates or margins generally a multiple like enterprise value to EBIT I should be correlating with eBay da growth any comparables this is because the discount rate and the free cash flow growth rate effect accompanies terminal value and therefore it's implied multiple out of a DCF analysis but the discount rate is similar for most of the companies in the set so if you're looking at a set of manufacturing companies or biotech companies or telecom companies and they're all in roughly the same size range the same industry the discount rate is generally going to be pretty similar so free cash flow growth is really the key driver that determines the company's terminal value the present value of its terminal value and therefore much of its value from a DCF and free cash flow growth should really trend with eBay da growth because revenue growth and operating or eBay down margins are the key drivers and the key things that will flow into free cash though and truly affect its growth rate now in real life this correlation often doesn't hold up that well especially for more speculative industries tech startups pharmaceutical biotech companies anything like that that tends to have a lot of volatility and a lot of people speculating on what's going to happen acquisitions and other items that go into free cash flow could also greatly distort maybe the numbers are not wrong at all maybe the market is not being completely insane it's just that perhaps it's undervaluing or overvaluing a company or analyzing and these are the types of cases that you're looking for where one company's growth rates are at or above many of the other companies in the set but for some reason it's treating at a lower multiple and that could be a sign that the company is actually undervalued so that's it for this lesson I hope you learned a little bit more about the relationship between valuation multiples growth rates and margins what to look for why there should be a correlation but why that correlation often doesn't exist or why it's sometimes weak in practice you

Channel: Mergers & Inquisitions / Breaking Into Wall Street

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Keywords: EBITDA Growth, Valuation Multiples, Growth Rates, EBIT Growth, multiples valuation, EBITDA Margins, EV / EBITDA, EBIT Margins, valuation, DCF, discounted cash flow, discounted cash flow analysis, EBITDA, Enterprise Value, FCF, Free Cash Flow, Discount Rate, WACC, Revenue Growth, Operating Margins, Operating Income Growth, terminal value, Margins, Excel Model Tutorial, TheStreet, Investment, mergers and inquisitions, ebitda multiple valuation, breaking into wall street

Id: RCs8M1MILyw

Length: 22min 41sec (1361 seconds)

Published: Tue Sep 01 2015