0:08

Welcome back.

Â We are talking about multiples today.

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

Â I'm starting very logically.

Â I know you know a lot of finance, but

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

Â 0:41

Turns out that when you value something using multiples,

Â you've got to get a comparable right.

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

Â The comparable better be your same business.

Â Remember beta asset, unlevering and all that?

Â Same logic.

Â 1:07

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

Â talking about, the real world a little bit.

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

Â Multiple p divided by e.

Â 1:47

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

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

Â So why earnings?

Â Why not free cash flow?

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

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

Â 2:15

Suddenly have huge spikes and even become negative.

Â Whereas earnings are less susceptible to it.

Â And the earnings that people use are not

Â the kind of cash flow we are talking about.

Â But we are talking about earnings from accounting statements.

Â So why are cash flows more choppy than earnings?

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

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

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

Â can affect the ratio.

Â So we use earnings.

Â Now that comes with advantages and disadvantages.

Â 2:58

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

Â Remember there's no debt.

Â But when debt comes, then things will get complicated.

Â So, for time being assume no debt.

Â 3:09

When we consider P P/E ratios.

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

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

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

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

Â So just remember that.

Â Often we don't.

Â So what do you do to price earnings ratios?

Â How do you adjust them?

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

Â And the reason is as I adjusted before,

Â growth is something that affects things disproportionately.

Â So one of the adjustments we make, and

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

Â P-E-G ratio.

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

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

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

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

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

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

Â use other information as well.

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

Â you wonder what its all about.

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

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

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

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

Â 4:54

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

Â Earnings are contaminated by a lot of stuff.

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

Â So for example,

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

Â Remember we talked about that.

Â So these are kind of issues that effect earnings and

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

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

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

Â 6:18

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

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

Â So debt now is positive as is equity.

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

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

Â 6:38

We adjust them for growth, yes, PEG ratios.

Â But what do you do with leverage?

Â Think about it.

Â It's very complicated.

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

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

Â Bottom line, depends, and

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

Â You don't have a hard and fast rule.

Â You can actually derive the conditions under which P/B

Â ratios will behave in a certain way.

Â But you've got to be very careful.

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

Â or leverage.

Â It's very obvious that net income,

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

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

Â Net earnings go to the shareholders.

Â 7:35

But who gets paid first?

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

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

Â They may choose to invest it back in the firm.

Â But you've got to pay interest.

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

Â right there.

Â So two firms in identical businesses,

Â and you want to use your comparables in those businesses.

Â One may have leverage, one may not.

Â Their earnings will defer simply because of leverage.

Â What about price?

Â Remember price to earnings ratio.

Â So earnings are dramatically directly, maybe not dramatically, but

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

Â What about price?

Â Well, you know price is effected by leverage too,

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

Â 8:42

increases value and who gets that increase in value?

Â Not the debt holders.

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

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

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

Â So interest tax shields raise the value of the stock or

Â stock price per share is the same thing.

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

Â dividends, which have a negative impact on price.

Â Do you see what I'm saying here?

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

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

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

Â 9:30

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

Â reinvest in hopefully positive NPV projects.

Â So what is the overall effect?

Â Unfortunately, it depends.

Â 9:43

And therefore, the effects of debt are extremely important

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

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

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

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

Â go up or down with leverage.

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

Â in an ambiguous way in the end.

Â