0:08

Welcome back.

We are talking about multiples today.

And I gave you some exposure to how multiples can be thought of, but

I'm starting very logically.

I know you know a lot of finance, but

it's very easy to get confused with multiple moving parts.

0:41

Turns out that when you value something using multiples,

you've got to get a comparable right.

So we now know two things about the comparable that we've gotta get right.

The comparable better be your same business.

Remember beta asset, unlevering and all that?

Same logic.

1:07

In the next segment, I'm going to spend some time sticking with not debt but

talking about, the real world a little bit.

In the real world, the most commonly used multiple is price to earnings

Multiple p divided by e.

1:47

And if there's no debt, that's the value per share as well.

Its the value of equity per share and it's value of the firm per share.

So why earnings?

Why not free cash flow?

In the real world, we don´t divide value by free cash flow because

free cash flow can be very, very choppy and even negative at times.

2:15

Suddenly have huge spikes and even become negative.

Whereas earnings are less susceptible to it.

And the earnings that people use are not

the kind of cash flow we are talking about.

But we are talking about earnings from accounting statements.

So why are cash flows more choppy than earnings?

Because earnings do not worry about below the line items, i.e.,

huge amounts of working capital changes could happen, but more importantly, capex.

So if you have a lot of capex happening, it happens sporadically and

can affect the ratio.

So we use earnings.

Now that comes with advantages and disadvantages.

2:58

The reason for price per share is simply because equity trades per share.

Remember there's no debt.

But when debt comes, then things will get complicated.

So, for time being assume no debt.

3:09

When we consider P P/E ratios.

One of the practices that you have to keep in mind is that you

want the earnings of future year, you remember FCF one.

You want to have earnings of next year, not today's, because the value of

something is the first year's cash flow valued or discounted.

So just remember that.

Often we don't.

So what do you do to price earnings ratios?

How do you adjust them?

So the first adjustment you need to make is for growth, right?

And the reason is as I adjusted before,

growth is something that affects things disproportionately.

So one of the adjustments we make, and

it's, I would encourage you to look at the screen now, is called the PEG ratio.

P-E-G ratio.

I'm not going to write it out, because it's very simple.

It's P divided by E ratio, which is the price to earnings ratios we

have been talking about, and adjusted for earnings growth rate.

And you can figure that out given the data in the recent past.

So, or projected to be the growth rate in the future, right?

Based on past data, you project a certain growth rate and

use other information as well.

So the PEG ratio you'll find a lot if you go to Yahoo finance or otherwise and

you wonder what its all about.

It is just adjusting for the fact that growth rates are firms even in the same

businesses, but all businesses can be different and its adjusting for it.

However, there are other issues and I want to just start talking about them and

then do a whole section on why P ratios can have problems.

4:54

First of all, think about the ratio P/E.

Earnings are contaminated by a lot of stuff.

Non-operational items, such as gains and losses on asset sales.

So for example,

earnings are effected by the amount of gain you may have if you sell an asset.

Remember we talked about that.

So these are kind of issues that effect earnings and

you got to keep that in mind because they are not really real in some sense.

They're affected by things that free cash flows are not effected.

However, because free cash flows are choppy, earnings are used instead.

6:18

Turns out a lot of firms carry debts but that has implications for

all kinds of ratios we use, and that's why we're going to talk about it.

So debt now is positive as is equity.

And this is what we're going to assume moving forward.

So what happens to b ratios that we use so commonly?

6:38

We adjust them for growth, yes, PEG ratios.

But what do you do with leverage?

Think about it.

It's very complicated.

And the reason it's complicated is both the numerator of the PE ratio, and

the denominator are effected by leverage and the bottom line is not simple.

Bottom line, depends, and

that's another reason why you want to be very careful with the ratios.

You don't have a hard and fast rule.

You can actually derive the conditions under which P/B

ratios will behave in a certain way.

But you've got to be very careful.

So first of all, how come earnings are affected by debt,

or leverage.

It's very obvious that net income,

which is also what we use in earnings in the real world falls with leverage.

And the reason is remember who does net earnings go to?

Net earnings go to the shareholders.

7:35

But who gets paid first?

The accounting person will remind you over and over again that you got to pay

interest before you get dividends or cash flow to equity holders.

They may choose to invest it back in the firm.

But you've got to pay interest.

As soon as you pay interest what happens is earnings are affected by leverage

right there.

So two firms in identical businesses,

and you want to use your comparables in those businesses.

One may have leverage, one may not.

Their earnings will defer simply because of leverage.

What about price?

Remember price to earnings ratio.

So earnings are dramatically directly, maybe not dramatically, but

directly effected by leverage, and dramatically if there's a lot of debt.

What about price?

Well, you know price is effected by leverage too,

but here, it's a little bit complicated and throws things off.

8:42

increases value and who gets that increase in value?

Not the debt holders.

Their problem is amount of payment and interest in face value.

What effects it happens is, it increases the price of the stock

because the stock holders gain that subsidy that the government gives.

So interest tax shields raise the value of the stock or

stock price per share is the same thing.

However, the fact that you have to pay interest reduces earnings and

dividends, which have a negative impact on price.

Do you see what I'm saying here?

So on the one hand the tax shield benefits you, but

on the other hand the fact that your interest, and you gotta pay it.

Much as you hate to do so, you got to, it's an obligation.

9:30

It reduces the earnings available to you to either pay yourself as dividends, or

reinvest in hopefully positive NPV projects.

So what is the overall effect?

Unfortunately, it depends.

9:43

And therefore, the effects of debt are extremely important

to take into account when you're considering P/E ratios.

In fact, what I would strongly recommend is taking a break, thinking through this.

I would also recommend you try to figure out, and this is difficult,

what kind of relationships can you derive to make sense of when will the P/E ratio,

go up or down with leverage.

As I told you, earnings are affected directly but prices are also affected but

in an ambiguous way in the end.