How to Determine Valuation in Investment Banking

Valuation (the process of putting a price tag on a company) is one area where most investors appreciate the value of comparison. In investment banking, you must consider the value of financial valuation ratios, including the price-to-earnings (P/E) ratio and the enterprise value–to–EBITDA (EV/EBITDA) ratio.

P/E

The P/E ratio tells you how much investors are paying for a claim to $1 of a company's earnings. When it comes to valuation ratios, the P/E is certainly one of the most famous because many people use it as a benchmark to tell them if a stock is relatively cheap or expensive.

The trouble is, though, that the P/E doesn't tell you much by itself. The ratio is most valuable when compared to that of similar companies or even the entire stock market. Keep in mind, too, that P/E ratios rise and fall as stock prices fluctuate and earnings change.

There are several different ways to calculate a P/E, so you'll want to use the same method for all the companies in your universe. It's best to compare a company's P/E to that of its peers, but it can also be interesting to look at how a company's P/E compares to the market over different points in time. You can see the trailing P/E of the Standard & Poor's 500.

Date Operating P/E (Trailing)
December 31, 2012 14.7
December 31, 2011 13.0
December 31, 2010 15.0
December 31, 2000 23.5
December 31, 1990 14.6

Source: S&P Dow Jones Indices

EV/EBITDA

The P/E is a helpful benchmark of company's value in large part due to simplicity. If you have access to a computer and financial websites, you can get a company's P/E pretty quickly. But investment bankers usually dig deeper, using EV/EBITDA, where EV is enterprise value and EBITDA is earnings before interest, taxes, depreciation, and amortization.

But for now, know that EV/EBITDA is best appreciated when used to look at a valuation of a company compared with its peers. Calculating EV/EBITDA requires a calculation using data, pulled from the financial statements.

Data Point Financial Statement Line Item ($ millions)
Market value 16,119.64
Cash and short-term investments 466.2
Total debt and minority interest 2,007.01
Total revenue 6,644.25
Cost of goods sold 3,743.89
Selling, general, and administrative (SG&A) 1,692.05
Depreciation and amortization 194.74

Source: S&P Capital IQ as of December 31, 2012

The first task for the investment banker is to calculate enterprise value. You know the following:

Enterprise Value = Market Value - Cash and Short-Term Investments + Total Debt and Minority Interest

You can find all the data you need to plug into the formula to find:

Enterprise Value = $16,119.64 - $466.2 + 2,007.01 = $17,661 million

Take a deep breath. You're halfway there. Now it's time to calculate EBITDA. The formulas for EBITDA is as follows:

EBITDA = Total Revenue - Cost of Goods Sold - Selling, General, and Administrative + Depreciation and Amortization

Again, inputting the data, you find:

EBITDA = $6,644.25 - 3,743.89 - 1,692.05 + 194.74 = $1,403.05 million

Last, you divide enterprise value by EBITDA to find that Hershey had an EV/EBITDA ratio as of December 31, 2012, of 12.6.

But what does that mean? To find out, you perform the same calculation with other firms in the packaged foods and meats industry.

Competitor EV/EBITDA
Mondelez 7.9
General Mills 10.2

Source: S&P Capital IQ as of Dec. 31, 2012

Comparing Hershey's EV/EBITDA to select peers in its industry shows that investors are willing to pay a greater premium for shares of Hershey. This is important information for the investment bankers to consider when evaluating options for perhaps issuing stock or conducting a merger.

For this example, just two competitors are looked at. In a real-world analysis, you'd want to create a larger universe of competitors.

There are some online services, like Thomson-Reuters, that will help you take an average of the entire industry.

blog comments powered by Disqus
Advertisement

Inside Dummies.com

Dummies.com Sweepstakes

Win $500. Easy.