Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 33vPR ⋅NI⋅ +NI( 1 g )equitytt=equity NIr− g(3.16)Dividing both sides of equation (3.16) by net income, eventually leads to theintrinsic P/E multiple at time tvNI( 1 g )PR ⋅ +equityt=equity NINItr − g(3.17)A closer look at equation (3.17) reveals the fundamental determinants of theP/E multiple. Under the given assumptions, the P/E multiple is positively related tofuture (earnings) growth and negatively related to risk, as measured by the cost ofequity (Beaver & Morse 1978, p. 65-66). According to equation (3.17), a high dividendpayout ratio also has a positive impact on the P/E multiple. However, Thomas& Zhang (2004) show that this impact is a minor one.3.2.2 Intrinsic EV/EBIT multiple derived from the DCF modelThe EV/EBIT multiple gained popularity recently, especially among investmentbankers. Although a bit more complex than the derivation of the intrinsic P/Emultiple, it is possible to derive an intrinsic EV/EBIT multiple from the DCF valuationmodel. However, the two main assumptions are similar: NOPAT grows at aconstant rate year by year and the proportion of NOPAT a firm re-invests each yearFCFis fixed. Together, this means that FCF also grow at a constant rate g year byyear (Koller, Goedhart & Wessels 2005, p. 62). Using the same perpetuity relationshipas in the GGM, the entity value of a firm in the DCF formula (3.5) can be rewrittenasv=rFCF− gentityt+1t wacc FCF(3.18)