V O LU M E 2 4 | N U M B E R 3 | S U M MER 2 0 1 2

In This Issue: Growth, Value, and Payout Policy

Is Economic Growth Good for Investors? 8 Jay R. Ritter, University of Florida

Blinded by Growth 19 Javier Estrada, IESE Business School

Valuation with Market Multiples: How to Avoid Pitfalls 26 Robert W. Holthausen, University of Pennsylvania
When Identifying and Using Comparable Companies and Mark E. Zmijewski, The University of Chicago

Excess Cash and Shareholder Payout Strategies 39 Niso Abuaf, Pace University and Ramirez & Co., Inc.

Toward Real-Time Financial Reporting: 55 U. Mark Schneider, CEO, Fresenius Group

How to Reduce Investors’ Information Gap and the Cost of Capital

Pitfalls in Levering and Unlevering Beta and 60 Robert W. Holthausen, University of Pennsylvania,
Cost of Capital Estimates in DCF Valuations and Mark E. Zmijewski, The University of Chicago

An Entrepreneur’s Guide to Understanding the 75 V. Ravi Anshuman, Indian Institute of Management

Cost of Venture Capital Bangalore; John Martin, Baylor University; and
Sheridan Titman, University of Texas at Austin

Corporate Governance and the Cost of Capital: 84 Peter Kien Pham, Jo-Ann Suchard, and Jason Zein,
Evidence from Australian Companies University of New South Wales

Assessing Project Risk 91 Antonio E. Bernardo and Bhagwan Chowdhry, UCLA Anderson
School of Management, and Amit Goyal, Swiss Finance
Institute at University of Lausanne

The Terminal Value and Inflation Controversy 101 Daniel Kiechle and Niklas Lampenius,
University of Hohenheim
Valuation with Market Multiples: How to Avoid Pitfalls
When Identifying and Using Comparable Companies1

by Robert W. Holthausen, University of Pennsylvania

and Mark E. Zmijewski, The University of Chicago

lthough discounted cash flow (DCF) continues In this paper, we show that differences in operating

B
A to be the standard valuation method taught in
most business schools, many if not most corpo-
rate practitioners and their financial advisors use
characteristics can result in differences in multiples, and that
those differences in operating characteristics have different
effects on different kinds of multiples (unlevered earnings
a valuation method based on some type of market “multiple” versus EBIT versus EBITDA versus revenue). For example,
in conjunction with a DCF or other valuation technique. The over the last five years, Coke’s multiple of enterprise value to
numerator for most multiples is based on the value of the last fiscal year-end’s sales as a percentage of Pepsi’s multiple has
company (e.g., enterprise value) or the value of the company’s been even higher than that percentage for the enterprise value
equity, while the denominator for the multiple is usually a to EBITDA multiple (the median percentage difference was
measure related to earnings, cash flow, revenues, or even book 88%, with 25th and 75th percentile percentage differences
value. Alternative names for the market multiple valuation of 63% and 95%, respectively). So, even though Pepsi and
method include “comparable company valuation,” “guide- Coke are head-to-head competitors in the soft drink market,
line-company valuation,” “relative valuation analysis,” “direct it does not mean that they are good comparable companies for
comparison valuation,” and “twin company approach.” As one another for the purpose of a market multiple valuation.
is clear from the various names used to describe the market The main challenges in conducting a market multiple
multiple valuation method, comparable companies—or valuation are (1) identifying appropriate comparable compa-
“comps”—play a major role in this valuation method. Indeed, nies that are priced similarly to the company being valued
an important, if not the most important, step in a market and (2) making the necessary adjustments to the financial
multiple valuation is to identify the comparable companies. numbers that are used to measure the market multiples of
Although this valuation model is simple on the surface, the comparable companies as well as those used to value
identifying the right comps and then making proper use of the company of interest. The goals of such analyses are to
them is a highly involved and complex process. For example, align the characteristics of the comparable companies with
Coke (Coca Cola Company) and Pepsi (PepsiCo Inc.) are two those of the company being valued, and to make appropriate
competing brands of soft drinks known throughout the world. adjustments to the financial statement-based items so that the
They are direct competitors, but are they directly comparable valuation is not distorted by financial statement numbers that
for purposes of a market multiple valuation? Over the last five may not be relevant for a market multiple valuation.
years, by our calculations, Coke’s multiple of enterprise value The aim of this paper is to summarize the key issues
to last fiscal year-end’s EBITDA has been consistently higher related to identifying and using comparable companies in
than Pepsi’s multiple (the median percentage difference was a market multiple valuation. We begin with an outline of
34%; the 25th and 75th percentile percentage differences a simple framework underpinning market multiple valua-
were 19% and 36%, respectively). tions—the case of a cash flow perpetuity. Next, we discuss the
What causes the differences in the market multiples complexities of comparability in real world settings, includ-
of these two companies? Is it differences in the underlying ing the importance of controlling for differences in various
operating characteristics of the companies? Are these differ- value drivers such as growth, risk, capital structure, capital
ences the same for all market multiples—for example, in the expenditure requirements, and other operating characteristics
case of EBIT and unlevered earnings? Although Coke states with the aim of improving comparability. In order to illustrate
that its business is nonalcoholic beverages, it generates most these complexities, we use the case of Staples Inc. to simulate
of its revenues from the sale of concentrates and syrups and, the effects of differences in these value drivers on Staples’
to a limited extent, the sale of finished beverages. Pepsi, on multiples. This simulation provides insights into the value
the other hand, generates revenues from not only finished drivers relevant for assessing the comparability of companies
beverages, but also from a variety of snack products. in a market multiple valuation and how important those value
1. This article is based on on Chapters 13 and 14 of Corporate Valuation: Theory, Business Publishers.
Practice and Evidence, by Robert Holthausen and Mark Zmijewski, © 2012, Cambridge

26 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
drivers are likely to be for assessing comparability for different payout ratio based on its earnings in order to establish the
kinds of multiples.2 link between free cash flow and earnings. While this exten-
sion is typically justified in terms of the general tendency of
The Basic Framework free cash flows and earnings to move together, it is far too
The basic framework underpinning the market multiple valu- simplistic and imprecise to provide a reliable basis for deter-
ation method begins with the following well-known constant mining the value drivers on which to assess comparability
growth perpetuity discounted cash flow (DCF) valuation when using earnings-based multiples. The imprecision in this
formula, in which an all-equity financed company being case results from the complexity of the relation between free
valued is assumed to generate a level of free cash flow (FCF) cash flows and different earnings measures that one would use
that grows at a constant rate forever: in a market multiple valuation—a complexity that is unlikely
FCF1 to be captured by a payout ratio adjustment.
VF, 0 = We start by considering the calculation of free cash flow.
r –g 1,∞ Free cash flow is equal to unlevered earnings (EBIT minus
where FCFt is the expected free cash flow in period t, gn, m is income taxes on EBIT) adjusted for non-cash expenses, accru-
the constant growth rate for the company’s free cash flows als, and investments. The most common non-cash expense is
from period n to period m, and r is the appropriate discount depreciation and amortization, which is added back to EBIT
rate.3 Using this formula, we can derive the free cash flow as part of the calculation of free cash flow. Accrual adjust-
market multiple (MM) as follows: ments include adjustments for changes in non-cash working
V 1 capital, such as changes in accounts receivable, prepayments,
MM[VF,0 /FCF1 ] = F, 0 = accounts payable, and various accrued expenses. In addition,
FCF1 r − g 1, ∞
accrual adjustments include adjustments for the conversion
If we use free cash flow from Year 0 (instead of Year 1), this of income tax expense into income taxes paid by adjust-
formula would include the growth rate from Year 0 to Year ing income tax expense for deferred income taxes, income
1 as follows: taxes payable, and net operating loss carryforwards. The
V (1 + g 0,1) aim of these adjustments is to convert EBIT into a measure
MM[VF,0 /FCF0 ] = F, 0 = of unlevered operating cash flow (what the operating cash
FCF0 r − g 1, ∞
flow would be if the company were unlevered). Finally, by
As these formulas illustrate, the free cash flow multiple is subtracting capital expenditures from unlevered operating
equivalent to the so-called “capitalization” factor in the cash flow, one arrives at an estimate of free cash flow.
constant growth perpetuity model. It can be interpreted as What is clear from the calculation of free cash flow from
the “price” that the market is currently paying for a dollar of EBIT is that factors more complex than a simple payout
free cash flow, given the market’s expectations of the future ratio—particularly differences in required working capital
growth of the cash flows.4 One of the main insights from and capital expenditures—affect the comparability of compa-
this framework is that risk and growth are primary deter- nies for market multiple valuation purposes. Naturally, the
minants of the comparability of companies when using free extent to which these factors matter depends on the specific
cash flow related multiples; and this result implies that when valuation context, but it is clear that factors other than risk
identifying comparable companies, analysts should identify and growth can be important for assessing comparability,
comparable companies based on at least these two value driv- and the list goes beyond investments in working capital and
ers.5 And as we will show later, in addition to risk and growth, capital expenditures.
which affect all multiples (not just free cash flow multiples),
other value drivers such as cost structure, investment require- The Case of Staples, Inc.
ments, and capital structure come into play as well when To illustrate the effects of various value drivers on different
assessing comparability for many multiples. market multiples, we use a simple financial model to value
Staples, Inc. The goal of this simulation is not to create the
Getting from Free Cash Flows to Earnings ultimate financial model and DCF valuation for Staples, but
Some authors extend this free cash flow framework to earn- rather to use a straightforward financial model and DCF
ings-based measures by simply applying a company’s dividend valuation that illustrate the relations between different value
2. While adjustments to the financial statements for measuring market multiples is we can always measure value by using some constant growth rate in a cash flow perpe-
also a complex and time-consuming task, a discussion of these adjustments is beyond tuity model. Thus, our discussion applies to all firms, not just firms that have a constant
the scope of this paper. expected growth rate for free cash flows.
3. For an all equity firm, the equity cost of capital, the unlevered cost of capital, and 5. As is true with the perpetuity model, the free cash flow in the base-year must be
weighted average cost of capital are identical. If the firm had debt in its capital structure, positive in order to use the market multiple valuation method.
the appropriate discount rate would be the weighted average cost of capital.
4. Naturally, for this calculation to make sense, expected free cash flows do not have
to grow at a constant rate. As long as the base-year expected free cash flow is positive,

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 27
Table 1 Staples, Inc. Historical Income Statement and Forecasts

  ($ in thousands) Jan-11 Jan-12 Jan-13 Jan-18 Jan-23

Income Statement Forecast Drivers:

Inflation 3.0% 3.0% 3.0% 3.0%
Revenue Growth Rate 1.9% 6.8% 4.0% 3.0%
Cost of Goods Sold (% Rev) 73.1% 73.1% 73.1% 73.1% 73.1%
Selling, General and Administrative (% Rev) 18.2% 18.5% 18.5% 18.5% 18.5%
Depreciation (Average years) 13.9 13.9 13.9 13.9
Income Tax Rate 34.5% 32.6% 34.5% 34.5% 34.5%

Income Statement:
Revenue $24,545,113 $25,022,192 $26,712,327 $34,053,976 $39,792,810
Cost of Goods Sold -17,938,958 -18,280,364 -19,515,119 -24,878,679 -29,071,276
Gross Margin $6,606,155 $6,741,828 $7,197,208 $9,175,297 $10,721,534
Selling, General and Administrative -4,476,014 -4,631,338 -4,944,164 -6,303,024 -7,365,220
Depreciation -437,174 -417,154 -467,950 -734,584 -1,109,127
Amortization of Intangibles -61,689 -64,902 -64,902 -64,902 -64,902
Integration and Restructuring Costs -57,765 0      
Operating Income $1,573,513 $1,628,434 $1,720,192 $2,072,787 $2,182,285
Interest and Other Income -2,094 4,458
Interest Expense -214,824 -173,751 -70,000 -70,000 -70,000
Income Before Taxes $1,356,595 $1,459,141 $1,650,192 $2,002,787 $2,112,285
Income Tax Expense -468,026 -475,308 -569,316 -690,962 -728,738
Non-Controlling Interests -6,621 823
Net Earnings $881,948 $984,656 $1,080,875 $1,311,826 $1,383,547

drivers and the commonly used market multiples. While the billion ($11.2 = $10.4 + $1.0 – $0.2). We use a 12% discount
relations are affected by the form and assumptions under- rate and assume Staples does not hold any excess cash in the
pinning the financial model, they are sufficiently general to future.
provide guidance about which value drivers are relevant for Along with two years of Staples’ historical financial state-
assessing comparability for different kinds of multiples.6 ments and free cash flows, we show (in Tables 1-3) selected
years of forecasts for fiscal year-ends January, 2013 to January,
Overview of the Financial Model and Discounted 2023 from the financial model and show the forecast assump-
Cash Flow Valuation tions for the income statement and balance sheet at the top
At the end of its 2011 fiscal year (January 2012), Staples was of Tables 1 and 2. We create a DCF valuation based on the
trading with an equity market capitalization of approximately financial model that was designed to produce a value equal
$10.4 billion. It had roughly $2 billion of debt and $1.2 billion to Staples’s actual value as of the end of fiscal 2011 (January,
of cash and equivalents. We eliminate assumed excess cash 2012). We achieve this through our choice of the fiscal 2012
of $1 billion and use it to reduce Staples’ debt to $1 billion. initial revenue growth rate, 6.8%, which we assume decays
To simplify the effects of capital structure, we assume the by 10% annually until it settles at the assumed long-term
company will maintain that level of debt in the future. After inflation rate of 3%. This initial revenue growth rate and the
reducing its debt to $1 billion, the resulting enterprise value other assumptions in the model produce a valuation equal to
of Staples (market value of the debt and equity less the value Staples’s actual value at the end of fiscal 2011.
of the cash) at the end of fiscal 2011 is approximately $11.2 As reported at the top of Table 1, for the other items on
6. An alternative to such a simulation is to derive the forms of various market multiples model can quickly become complex. This simulation is an alternative approach based on a
based on a series of time-series models for all of the income statement and balance sheet financial model that illustrates the effects of different value drivers on various multiples.
items. Unfortunately, the formulas for the market multiples for even a simple financial

28 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
Table 2 Staples, Inc. Historical Balance Sheet and Forecasts

  ($ in thousands) Jan-11 Jan-12 Jan-13 Jan-18 Jan-23

Balance Sheet Forecast Drivers:

Required Cash Balance (% Rev) 0.9% 0.9% 0.9% 0.9% 0.9%
Accounts Receivable (Days to Collect) 29.3 29.7 29.7 29.7 29.7
Inventory (Days to Sell) 48.0 48.6 48.6 48.6 48.6
Other Current Assets (% Rev) 2.8% 2.2% 2.2% 2.2% 2.2%
Other Non-Current Assets (% Rev) 2.9% 2.5% 2.5% 2.5% 2.5%
Accounts Payable (Days to Pay) 44.2 44.2 44.2 44.2
Accrued Expenses (% Rev) 6.1% 5.7% 5.7% 5.7% 5.7%
Non-Current Liabilities (% Rev) 2.7% 2.9% 2.9% 2.9% 2.9%

Balance Sheet:
Required Cash $221,661 $225,969 $241,232 $306,486 $358,135
Short-Term Investments 1,239,596 1,038,180
Accounts Receivable 1,970,483 2,033,680 2,171,046 2,767,739 3,234,163
Inventories 2,359,173 2,431,845 2,596,105 3,309,622 3,867,365
Other Current Assets 677,254 561,146 599,049 763,692 892,391
Total Current Assets $6,468,167 $6,290,820 $5,607,432 $7,147,538 $8,352,054
Land, Buildings, and Equipment, Net 2,147,771 2,080,361 2,220,880 2,831,269 3,308,400
Goodwill and Other Intangible Assets 4,595,884 4,431,911 4,367,009 4,042,499 3,717,989
Other Non-Current Assets 699,845 627,530 669,917 854,038 997,961
Total Assets $13,911,667 $13,430,622 $12,865,237 $14,875,344 $16,376,404

Accounts Payable $2,208,386 $2,220,414 $2,380,880 $3,025,267 $3,530,772

Accrued Expenses and Other 1,497,851 1,414,721 1,510,279 1,925,366 2,249,832
Short-Term & Current Long-Term Debt 587,356 439,143      
Total Current Liabilities $4,293,593 $4,074,278 $3,891,159 $4,950,633 $5,780,603
Long-Term Debt 2,014,407 1,599,037 1,000,000 1,000,000 1,000,000
Other Long-Term Obligations 652,486 735,094 784,746 1,000,427 1,169,021
Total Liabilities $6,960,486 $6,408,409 $5,675,905 $6,951,059 $7,949,624
Common Stock and Surplus $548,303 $135,834 $135,834 $135,834 $135,834
Other -89,462 -312,681 -312,681 -312,681 -312,681
Retained Earnings 6,492,340 7,199,060 7,366,180 8,101,132 8,603,627
Total Shareholders Equity $6,951,181 $7,022,213 $7,189,333 $7,924,285 $8,426,780
Total Liabilities and Equities $13,911,667 $13,430,622 $12,865,237 $14,875,344 $16,376,404

the income statement, the financial model assumes that the other non-current assets, as well as all accrued expenses and
company’s cost of goods sold and selling, general, and admin- non-debt non-current liabilities, continue to equal the same
istrative expenses in all future years are the same percentage of percentage of revenues as in fiscal 2011. Net land, build-
revenues that they were in 2011. It also assumes straight-line ings, and equipment grow at the same rate as revenues, and
depreciation based on the 2011 straight-line depreciation rate, capital expenditures equal depreciation plus the growth in net
constant amortization of intangibles (no acquisitions), and an land, buildings, and equipment. The model sets goodwill and
income tax rate of 34.5%. other intangible assets at the fiscal 2011 value less amortiza-
As shown at the top of Table 2, for the company’s tion taken on the income statement (again, no acquisitions).
balance sheet, the model assumes that all current assets and Table 3 presents the free cash flows that are calculated from

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 29
Table 3 Staples, Inc. Historical Free Cash Flow Schedules and Forecasts

($ in thousands) Jan-11 Jan-12 Jan-13 Jan-18 Jan-23

Earnings Before Interest and Taxes (EBIT) $1,573,513 $1,628,434 $1,720,192 $2,072,787 $2,182,285
Income Taxes Paid on EBIT -542,863 -530,454 -593,466 -715,112 -752,888
Earnings Before Interest and After Taxes $1,030,650 $1,097,980 $1,126,725 $1,357,676 $1,429,397
Depreciation and Amortization 498,863 482,056 532,852 799,486 1,174,029
Other Adjustments 158,918 153,646
Change in Receivables -95,656 -73,670 -137,366 -106,157 -94,199
Change in Inventories -46,450 -82,343 -164,260 -126,941 -112,642
Change in Other Current Assets -70,600 123,660 -37,903 -29,291 -25,992
Change in Accounts Payable 63,305 23,677 160,466 114,463 102,838
Change in Accrued Expenses and Other -191,917 -117,389 95,558 73,848 65,529
Change in Other Non-Current Assets 172,630 6,706 -42,387 -32,757 -29,067
Change in Other Non-Current Liabilities 75,450 75,476 49,652 38,371 34,049
Change in Required Cash Balance 0 -4,308 -15,263 -11,755 -10,431
Unlevered Cash Flow from Operations $1,595,193 $1,685,490 $1,568,075 $2,076,943 $2,533,511
Capital Expenditures, Net -471,955 -383,654 -608,469 -843,178 -1,205,488
Unlevered Free Cash Flow $1,123,238 $1,301,836 $959,606 $1,233,765 $1,328,023
Interest Expense -214,824 -173,751 -70,000 -70,000 -70,000
Interest Tax Shield 74,114 56,599 24,150 24,150 24,150
CF Before Non-Equity Financing Changes $982,529 $1,184,684 $913,756 $1,187,915 $1,282,173
Change in Debt, Net -5,912 -518,788 0 0 0
Equity Free Cash Flow $976,617 $665,896 $913,756 $1,187,915 $1,282,173

the income statement and balance sheet forecasts in Tables unlevered earnings multiple (earnings after adding back
1 and 2.7 after-tax interest), sometimes referred to as NOPAT or net
Using the Staples financial model, we examine the effect operating profits after tax. Of course, the calculation of
of the variation in value drivers on a variety of commonly used unlevered earnings makes no adjustment for investments
multiples. We have already discussed the unlevered free cash in capital expenditures and working capital, nor does it
flow market multiple that measures enterprise or firm value. add back non-cash expenses (like depreciation) or non-cash
While it is perhaps the most basic multiple, it is not used as revenues. The unlevered earnings multiple is not as widely
frequently as some earnings-based multiples that also measure used as two other enterprise value multiples—EBIT multiple
enterprise value because it is more likely to include transitory (earnings before interest and taxes) and EBITDA multiple
components, such as lumpy capital expenditures, temporarily (earnings before interest, taxes, depreciation and amortiza-
high or low receivables or payables, and temporary accruals. tion). The relation of EBIT and EBITDA to unlevered free
Analysts use a variety of accounting statement-based multiples.8 cash flows is less direct than the relation between unlevered
All of the denominators used in these multiples have some earnings and unlevered free cash flows. Still another income
relation to free cash flows, but those relations can vary greatly. statement-based multiple is the enterprise value to revenue
Since the relations of the alternative denominators to free cash or sales multiple, which of course is even less directly related
flows can be different, the effect of variation in specific value to unlevered free cash flows. We also examine a multiple of
drivers on different multiples can be different as well. enterprise value to total invested capital. The three different
The earnings-based multiple that is most similar to the equity value multiples we examine are based on equity free
unlevered free cash flow multiple is the enterprise value to cash flows, earnings, and book value of equity.
7. The January, 2012 balance sheet numbers are as reported by Staples. We made 8. We note that there are a variety of multiples that have a non-accounting denomina-
the adjustment to Staple’s excess cash (short term investments) and debt subsequent to tor that are used in particular industries. Some example denominators are measures of
January 2012, but do not show the restated balance sheet. In addition, we do not incor- productive capacity, square feet of retail space, passenger miles and more. While a dis-
porate the liquidation of the short term investments and associated reduction in debt cussion of these is beyond the scope of this paper, there are important comparability is-
described previously in the free cash flow calculation for the January 2013 forecast sues associated with using those multiples as well.
contained in Table 3.

30 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
Table 4 Staples, Inc. Market Multiples (Using January 2012 Valuation Divided by January 2013 Forecast)

      Numerator Denominator Multiple

Total Enterprise Value-Based Multiples
Unlevered Free Cash Flow Multiple $11,210,184 $959,606 11.7
Unlevered Earnings Multiple $1,126,725 9.9
EBIT Multiple $1,720,192 6.5
EBITDA Multiple $2,253,044 5.0
Revenue (Sales) Multiple $26,712,327 0.4
Total Invested Capital Multiple $8,189,333 1.4

Equity Capitalization-Based Multiples

Equity Free Cash Flow Multiple $10,436,153 $913,756 11.4
P/E or Earnings Multiple $1,080,875 9.7
Market-to-Book Multiple $7,189,333 1.5

In Table 4, we present the calculation of the above investments in capital expenditures and working capital—
market multiples based on Staples’ actual enterprise value, cause variation in market multiples? Second, to what extent
the company’s equity value, and the forecasts of the relevant does variation in those value drivers affect different multi-
denominators in Tables 1 through 3. More specifically, the ples—for example, does variation in cost structure affect
multiples equal the company’s enterprise value or equity all multiples to the same degree or not? A value driver can
value as of January 2012 divided by the fiscal 2012 (January affect a multiple by affecting the numerator (market value)
2013) forecast for the denominator. As reported in the top of the multiple, the denominator of the multiple, or both
panel of Table 4, Staples’s enterprise value-based multiples the numerator and denominator in different proportions.
include a free cash flow multiple of 11.7 and an unlevered If a value driver affects both a multiple’s numerator and
earnings multiple of 9.9. The difference between the two denominator by the same percentage, it will have no effect
multiples is primarily the result of capital expenditures on that market multiple; and in such a case, that value driver
(included in unlevered free cash f lows) that are larger is not important for assessing comparability across firms for
than the depreciation expensed on the income statement that particular multiple. As we illustrate below, when using
(included in unlevered earnings). Naturally, since EBIT is a particular multiple, a value driver is relevant for assess-
larger than unlevered earnings, the EBIT multiple of 6.5 ing comparability across firms if a difference in the value
is lower than the unlevered earnings multiple. And the driver affects the market value (numerator) of the multiple
EBITDA multiple of 5.0 is lower than both the EBIT and differently than it affects the denominator of that multi-
unlevered free cash flow multiples for the same reason. The ple in percentage terms. The more that variation in a value
revenue multiple is 0.4, and the multiple of total invested driver affects the numerator and denominator of the multi-
capital (TIC) is 1.4. ple differentially (in relative terms), the more important that
In the bottom panel of Table 4, we report the company’s value driver is for assessing comparability.
equity value-based multiples. Since the amount of financial In Tables 5 and 6, we summarize the results of our
leverage is less than 10% of Staples’ overall capital structure, simulation of the effect of differences in value drivers on
its equity value-based multiples are similar to the analogous the multiples reported in Table 4. The percentage change
enterprise value-based multiples. The equity free cash flow in the multiple is equal to one plus the percentage change
multiple of 11.4 and net income (or P/E) multiple of 9.7 are in the numerator value divided by one plus the percentage
similar to the unlevered free cash flow (11.7) and unlevered change in the denominator. The more sensitive the multi-
earnings (9.9) multiples. The market-to-book multiple is ple is to a change in a value driver, the more important
equal to 1.5, which is similar to the TIC multiple (1.4). that value driver is for assessing comparability. To partly
standardize the effect across value drivers, the change in
Effect of Differences in Value Drivers the value driver shown is the change necessary to increase
on Comparability the enterprise value of the firm by 10%, which for some
In this section of the paper, we ask two questions. First, assumptions requires a fairly large (and not always realis-
how does variation in certain value drivers—specifically, tic) change in the assumption.9 We begin our discussion by
risk, growth, financial leverage, cost structure, and required examining the effects of differences in risk and growth, and

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 31
Table 5 Staples, Inc. Illustration of the Effects of Changes in Value Drivers on Enterprise Value-Based Multiples

  Financial % Free Cash Unlevered EBIT EBITDA Revenue Total

Model Change in Flow Earnings Multiple Multiple Multiple Invested
Assumption Enterprise Multiple Multiple Capital
Value Multiple
Risk (Discount Rate) 12.0%   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 11.2% 12.9 10.9 7.2 5.5 0.5 1.5
% Change in Underlying Variable 10.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
% Change in Multiples 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Debt Financing $1 billion   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples $6 billion 12.9 10.9 7.2 5.5 0.5 1.5
% Change in Underlying Variable 10.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
% Change in Multiples 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Initial Revenue Growth Rate 6.8%   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 8.8% 13.4 10.7 7.0 5.4 0.5 1.5
% Change in Underlying Variable 10.0% -4.3% 2.3% 2.3% 1.9% 1.9% 0.8%
% Change in Multiples 14.9% 7.5% 7.5% 7.9% 7.9% 9.1%
Cost of Goods Sold % 73.1%   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 72.5% 11.7 10.1 6.6 5.1 0.5 1.5
% Change in Underlying Variable 10.0% 9.6% 8.2% 8.2% 6.3% 0.0% 0.0%
% Change in Multiples 0.4% 1.6% 1.6% 3.5% 10.0% 10.0%
Income Tax Rate 34.5%   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 28.3% 11.6 10.0 7.2 5.5 0.5 1.5
% Change in Underlying Variable 10.0% 11.0% 9.4% 0.0% 0.0% 0.0% 0.0%
% Change in Multiples -0.9% 0.6% 10.0% 10.0% 10.0% 10.0%
Net PPEQ Growth as % of Revenue 100.0%   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 32.7% 11.6 10.9 7.1 5.5 0.5 1.5
% Change in Underlying Variable 10.0% 10.4% 0.4% 0.4% 0.0% 0.0% -1.2%
% Change in Multiples -0.3% 9.5% 9.5% 10.0% 10.0% 11.3%
Days to Collect Receivables 29.7   11.7 9.9 6.5 5.0 0.4 1.4
New Assumption and Multiples 12.7 11.3 10.5 6.8 5.2 0.4 1.5
% Change in Underlying Variable 5.0% 8.2% 0.0% 0.0% 0.0% 0.0% -1.0%
% Change in Multiples -2.9% 5.0% 5.0% 5.0% 5.0% 6.1%

The table consists of multiple sets of rows, with each set of rows presenting the effect value driver and value of each multiple based on the revised value driver; the third row
of differences in a specific value driver on the different multiples shown in the columns presents the percentage change in enterprise value and the percentage change in the
of the table. The first row in a set of rows presents the original value driver and value of denominators of each of the multiples; and the last row presents the percentage change
each multiple based on the original value driver; the second row presents the revised in the multiple resulting from the change in the value driver.

then discuss the impact of other value drivers on various rate results in a difference in the value of the firm but it has no
market multiples. effect on any of the denominators. The resulting percentage
change in each of the enterprise value-based multiples is thus
Differences in Risk (Discount Rate) and equal to the percentage change in enterprise value, or 10%.
Capital Structure The effect on equity multiples is equivalent. As shown
The first set of rows in Table 5 illustrates the effect of a differ- in Table 6, given the assumption of a fixed amount of debt
ence in the discount rate (risk) on the enterprise value-based that initially represents only 9% of the company’s total value;
multiples. A reduction in the discount rate from 12% to 11.2% the increase in the value of the equity is 10.7%. Again, since
increases enterprise value by 10%. This is one of the easiest a difference in the discount rate has no effect on any of the
effects to understand. All else equal, a difference in the discount equity multiple denominators; the percentage change in the
9. The one exception is the change in the days to collect receivables assumption,
which is a change to increase the enterprise value of the firm by 5%.

32 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
Table 6 Staples, Inc. Illustration of the Effects of Changes in Value Drivers on Equity Value-Based Multiples

  Financial Model % Change in Equity Free Cash P/E or Earnings Market-to-Book

Assumption Equity Value Flow Multiple Multiple Multiple
Risk (Discount Rate) 12.0%   11.4 9.7 1.5
New Assumption and Multiples 11.2% 12.6 10.7 1.6
% Change in Underlying Variable 10.7% 0.0% 0.0% 0.0%
% Change in Multiples 10.7% 10.7% 10.7%
Initial Revenue Growth Rate 6.8%   11.4 9.7 1.5
New Assumption and Multiples 8.8% 13.2 10.4 1.6
% Change in Underlying Variable 10.7% -4.5% 2.4% 0.9%
% Change in Multiples 16.0% 8.1% 9.7%
Cost of Goods Sold % 73.1%   11.4 9.7 1.5
New Assumption and Multiples 72.5% 11.5 9.8 1.6
% Change in Underlying Variable 10.7% 10.1% 8.6% 0.0%
% Change in Multiples 0.6% 2.0% 10.7%
Income Tax Rate 34.5%   11.4 9.7 1.5
New Assumption and Multiples 28.3% 11.4 9.8 1.6
% Change in Underlying Variable 10.7% 11.1% 9.4% 0.0%
% Change in Multiples -0.3% 1.2% 10.7%
Net PPEQ Growth as % of Revenue 100.0%   11.4 9.7 1.5
New Assumption and Multiples 32.7% 11.4 10.6 1.6
% Change in Underlying Variable 10.7% 10.9% 0.4% -1.3%
% Change in Multiples -0.1% 10.3% 12.2%
Days to Collect Receivables 29.7   11.4 9.7 1.5
New Assumption and Multiples 12.7 11.1 10.2 1.5
% Change in Underlying Variable 5.4% 8.6% 0.0% -1.1%
% Change in Multiples -2.9% 5.4% 6.6%

The table consists of multiple sets of rows, with each set of rows presenting the effect value driver and value of each multiple based on the revised value driver; the third row
of differences in a specific value driver on the different multiples shown in the columns presents the percentage change in equity value and the percentage change in the de-
of the table. The first row in a set of rows presents the original value driver and value of nominators of each of the multiples; and the last row presents the percentage change in
each multiple based on the original value driver; the second row presents the revised the multiple resulting from the change in the value driver.

respective multiples is equal to the percentage change in the Thus, the effect of a change in capital structure on the
equity value (numerator), or 10.7%. In sum, differences in risk multiples is equivalent to the effect observed for the discount
affect all multiples and therefore risk is an important value rate.10 The resulting percentage change in each of the enter-
driver that should be roughly equivalent across all comparable prise value-based multiples is equal to the percentage change
companies and the company being valued. in enterprise value, or 10%. Naturally, financial leverage has
We show a similar effect from differences in capital struc- potentially more complicated relations with enterprise value
ture. One way that changing capital structure can affect the (for example, financial distress costs) that we are ignoring
value of the firm is through a change in the value of the here; but even with this simplistic assumption, we are able to
interest tax shields. Table 5 shows the effect of a change in show that capital structure can be an important value driver
the capital structure by increasing the debt from $1 billion to consider for assessing comparability.11
to $6 billion. An increase in debt of this magnitude increases In summary, the Staples simulation illustrates that
enterprise value by 10%; but as with changes in the discount differences in risk (discount rate) and capital structure can
rate, this change in capital structure has no effect on any of have an important role in assessing the comparability for all
the denominators of the enterprise value-based multiples. multiples.

10. We note that increasing the leverage is equivalent to reducing the discount rate 11. We do not show the effect of a change in capital structure on the equity value-
assuming interest is tax deductible, as we know that the weighted average cost of capital based multiples because such an increase in the amount of debt results in a recapitaliza-
declines with increases in leverage (assuming financial distress costs or other potential tion of the equity, which is not as helpful for providing useful insights on the change in
countervailing forces are not significant). the equity value-based market multiples.

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 33
Differences in Growth Rate revenue and TIC multiples (Table 5) change by the percentage
The next set of rows in Tables 5 and 6 illustrates the effect change in enterprise value of 10%. Similarly, since the model
of differences in revenue growth rates for assessing compara- assumes the company holds no excess cash and pays out all
bility. More specifically, we show the effect of changing the equity free cash flow as dividends, the market-to-book multiple
initial revenue growth rate from 6.8% to 8.8%. Changing the (Table 6) changes by exactly the percentage change in equity
initial revenue growth rate increases many of the subsequent value of 10.7%.
growth rates as the growth rate decays 10% annually from the The change in the cost of goods sold expense ratio increases
initial revenue growth rate until it settles to the assumed long- EBITDA by 6.3%, and it increases EBIT and unlevered earnings
term inflation rate of 3%. Unlike changes in the discount rate, by 8.2%. These changes in the denominators partly offset the
changes in the revenue growth rate affect both the market multi- effect of the increase in value of the numerators (Table 5). The
ple numerators and denominators. The effect of this change on result is that the EBITDA multiple increases by 3.5%, and
the revenue and EBITDA denominators is the same—that is, the EBIT and unlevered earnings multiples increase by 1.6%.
1.9%—and so the change in the respective multiples is 7.9% Unlevered free cash flow increases more than the earnings-based
(0.079 = 1.1/1.019-1). EBIT and unlevered earnings change denominators, 9.6%, because inventory and accounts payable
by 2.3%. This larger percentage change (2.3% versus 1.9%) has also change as a result of the change in the cost structure. The
the effect of reducing the percentage change of the respective result is that the unlevered free cash flow multiple is essentially
market multiples, which increase by 7.5%. unchanged (increase of 0.4%). We observe analogous affects for
Unlike the case of earnings-based multiples, the increase in the equity free cash flow and P/E multiples (Table 6).
the revenue growth rate actually has the effect of decreasing both The change in income tax rates has more of an effect on the
unlevered and equity free cash flow in fiscal 2012 because of EBIT, EBITDA, revenue, TIC and market-to-book multiples
the additional investments required for the additional growth. than on the other multiples because the denominators of these
While the starting point for the free cash flow calculation—that multiples are unchanged by a change in the income tax rate.
is, after-tax EBIT—increases, the increase in revenue from the The change in the respective multiples is equal to the change in
higher growth rate results in even larger percentage increases the enterprise value of the firm, 10%. Since unlevered earnings
in investments in working capital and net land, buildings, and includes a deduction for income taxes, it increases by 9.4% as a
equipment, which has the net effect of decreasing free cash flows result of the decrease in the income tax rate, which reduces the
in fiscal 2012. The overall effect on unlevered and equity free effect on the unlevered earnings multiple to 0.6%. Similarly,
cash flows is a decrease of ‑4.3% and ‑4.5%, respectively, and unlevered free cash flow also includes a deduction for income
this negative effect on the denominators results in an even larger taxes but investments in working capital and net, land, build-
effect on the respective multiples. The effects on the unlevered ings, and equipment are not tax deductible and unaffected by
and equity free cash flow multiples are 14.9% and 16%, respec- the change in the income tax rate. As a result, the effect on
tively. The denominators of the balance sheet-based multiples, unlevered free cash flow is 11%, and the unlevered free cash
TIC and market-to-book, change less than any of the free cash flow multiple decreases by -0.9%. We observe similar effects for
flow and earning-based multiples; and thus the percentage the equity free cash flow and P/E multiples (Table 6).
change in these multiples is close to the percentage change in The simulation illustrates how differences in operating
value (the numerator), 9.1% and 9.7%, respectively. cost structure (such as cost of goods sold and selling, general,
This simulation illustrates the importance of growth rates and administrative expenses) are most important for assessing
for assessing comparability. Moreover, depending on the charac- comparability when using balance sheet and revenue multi-
teristics of the firm, differences in revenue growth rates can ples and, to a lesser extent, the EBITDA multiple. They are
affect free cash flow multiples more than other multiples because much less important for assessing comparability when using
of their potential impact on capital expenditure and working the unlevered free cash flow, equity free cash flow, unlevered
capital investment, which do not affect (or have a very small earnings, and P/E multiples. The simulation also illustrates that
effect on) earnings-based or balance sheet-based multiples. differences in income tax cost structure are important to take
into account for assessing comparability when using balance
Differences in a Company’s Cost Structure sheet, revenue, EBITDA and EBIT multiples, but are much
The next two sets of rows in Tables 5 and 6 illustrate the effects less relevant for unlevered free cash flow, equity free cash flow,
of differences in cost structures. We illustrate the effect of such unlevered earnings and P/E multiples.
differences by changing the cost of goods sold expense ratio
and the income tax rate. The cost of goods sold expense ratio is Differences in Capital Expenditure Requirements and
assumed to fall from 73.1% to 72.5% for all future years. The Investments in Working Capital
tables also present the effect of changing the income tax rate The last two sets of rows in Tables 5 and 6 illustrate the
from 34.5% to 28.3% for all future years. effects of differences in required capital expenditures and
Since revenue and TIC are unaffected by these changes, the working capital investments. Capital expenditures affect only

34 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
income statement-based denominators if the capital expen- earnings-based and revenue multiples increase by the same
ditures are depreciated or amortized over the asset’s useful percentage as the enterprise value of the firm—again, 5%.
life and if the particular denominator includes the depreci- And once again, free cash flows increase as a result of the
ation and amortization deduction. And even if the capital change in working capital requirements, which reduces the
expenditure is depreciated, it will be depreciated over the change in the free cash flow multiple to -2.9%.
life of the asset and not all in one year. Thus, the effect on The simulation illustrates how taking account of differ-
income is smaller than the effect on free cash flows, at least ences in investment requirements (both capital expenditures
for the initial change in capital expenditure requirements.12 and working capital) can be important for assessing compa-
Investments in working capital (in this case, days to collect rability when using earnings-based, balance sheet-based and
receivables) have no effect on any component of earnings. revenue multiples. They are much less relevant for the free
As a result, differences in capital expenditure requirements cash flow multiples.
and investments in working capital will affect the value of
the firm, but have little or no effect on the components of Does Size Matter in the Choice of
earnings. The percentage change in earnings-based multiples Comparable Companies?
will be equal (or at least close) to the change in the market Although the effect of size on market multiples is beyond
value of the numerator. the scope of our analysis, it is an empirical question as to
The base assumption for capital expenditures is that whether or not firm size matters for comparability. Control-
net land, buildings, and equipment grow at 100% of the ling for the size of the comparable companies is popular in
revenue growth rate, and that capital expenditures equal practice when selecting comparable companies. However,
depreciation expense plus the revenue growth rate multi- there is no theoretical model that we are aware of that
plied by the balance in net land, buildings, and equipment. includes size as a determinant of market multiples. The
In this illustration, the new growth rate for net land, build- empirical research is mixed on whether or not controlling
ings, and equipment is assumed to be about one-third of the for size is helpful for choosing comparable companies after
revenue growth rate for all future years. This change reduces controlling for industry and other factors.13 On the other
capital expenditure requirements and increases the enter- hand, there is some evidence that firm size is correlated with
prise value of the firm by 10%. The financial model assumes some value relevant aspects of a company, and we know
the company expenses one year of depreciation in the year from research in finance that size appears to be correlated
the company makes the capital expenditure. Revenue and with returns even after controlling for expected returns
EBITDA are unaffected by capital expenditures, and thus measured using the Capital Asset Pricing Model. Thus, the
the percentage change in the respective multiples is equal use of the CAPM alone may not be sufficient to control for
to the percentage change in enterprise value. risk (or the discount rate) completely.14
Unlevered earnings and EBIT denominators are only
slightly affected by one year of depreciation and increase Using Market Multiples for Continuing or
by 0.4%. This increase in the denominators slightly offsets Terminal Value
the increase in the numerators and the multiples increase Using market multiples to measure a company’s continu-
by 9.5%. Free cash flows, by contrast, are affected dollar for ing or terminal value is not always the same as valuing a
dollar by capital expenditures. The free cash flows increase company (or its equity) as of the valuation date. Since the
by 10.4%, and the net effect on the free cash flow multiple continuing value date is some number of years after the valu-
is only ‑0.3%. The balance sheet multiples increase by more ation date, the main question or challenge here is to forecast
than the percentage increase in value because the effect of how the market multiples will have evolved by the continu-
decreasing capital expenditures is to shrink the balance ing value date. Thus, to use market multiples to measure
sheet. This decrease in the size of the balance sheet exacer- continuing value, the future growth and performance pros-
bates the effect on the balance sheet-based multiples. The pects (including capital expenditure and working capital
TIC multiple increases by 11.3%, and the market-to-book requirements) at the continuing value date of the company
multiple increases by 12.2%. The effects of working capital being valued must be the same as the current growth and
requirements are similar to the effect of capital expendi- performance prospects of the comparable companies that
tures. Decreasing the days to collect receivables from 29.7 will be used to measure the relevant continuing value
to 12.7 increases the enterprise value of the firm by 5% but market multiples from current data. And for that reason,
has no effect on the income statement; as a result, all of the the best comparable companies for a market multiple valu-

12. A sustained difference in depreciable capital expenditure requirements—for ex- 13. See for example, Alford, A. (1992) and Beatty, R., S. Riffe, and R. Thompson
ample, two companies that are in steady state—would affect earnings more significantly (1999).
than we are modeling in the Staples example where the impact on depreciation is from 14. See Banz, R. (1981), Keim, D. (1983), and Fama E. and K. French (1992).
a single year of additional capital expenditures.

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 35
ation of a company on the valuation date can differ from statements of the company being valued that are based on
the best comparable companies to assess the multiple at the midpoint of the cycle.
the company’s continuing value date. For example, if the
expected growth rate or the expected profitability is lower Conclusions
at the continuing value date than they are at the valuation Implementing a market multiple valuation with any preci-
date, the comparable companies for the current valuation sion is generally not as simple as calculating the mean or
and the continuing value calculation would be different. median multiple of every company in a particular SIC code
We illustrate this effect by demonstrating the change or industry. Controlling for the differences in value driv-
in market multiples of a company with high initial revenue ers across companies is necessary when trying to ensure
growth of 25% in Year 1, which declines to 20% and 8% the comparability of the comparable companies and the
in the next two years, and then to 2% thereafter. In Table company being valued. For example, value drivers such as
7, we present summary financial statement and free cash risk and growth are widely known to be important when
flow forecasts for such a company along with a valuation assessing the comparability of companies used in all kinds
of that company. The EBIT multiple declines from 10.9 to of market multiple valuations. In this paper, however, we
8.0 during the forecast period, a decline of over 25%, as a also show that many multiples are affected by value driv-
result of the decreasing growth rate. The unlevered earnings ers such as cost structure and working capital and capital
and EBITDA multiples decline by over 25% as well, while expenditure requirements. And complicating the choice of
the free cash flow multiples decline even more, from 58.8 comparables, is the fact that not all multiples are equally
to 10.5. affected by variations in particular value drivers. For exam-
In sum, assessing comparability when using market ple, when using a multiple in which expenditures (expenses
multiples to measure continuing value requires using compa- or investments) are not deducted in the calculation of the
rable companies that currently have value drivers similar denominator, that expenditure is more important for assess-
to the expected value drivers of the company of interest ing comparability than when using a multiple in which it is
(on all relevant dimensions) at the time of the continuing deducted in the calculation of the denominator.
value date. These expected future value drivers could be As a general rule, the unlevered free cash flow, equity
quite different than the company’s current value drivers. free cash flow, unlevered earnings, and earnings multiples
For example, if the company is currently growing rapidly are less affected by changes in a company’s cost structure
and is very profitable due to some competitive advantage than other multiples. For example, income taxes are more
that will not be sustainable at the continuing value date, important for assessing comparability when using multi-
then the comparables for the continuing value date should ples based on measures like EBIT, EBITDA, revenue, and
have a lower growth profile than the company’s current balance sheet-based measures such as book value and total
growth profile. invested capital. Similarly, depreciation and amortization
Even though we illustrated this concept using a declin- cost structure is more important for assessing compara-
ing revenue growth rate, the same type of effect occurs as bility for EBITDA and revenue and balance sheet-based
a result of declining profitability or any other change in a multiples than it is for other multiples. Since differences
value driver that occurs between the valuation date and the in capital expenditure and working capital requirements
continuing value date that affects a market multiple being can have significant effects on the value of the firm and
used to assess value. A related issue can arise for companies do not affect the denominator of certain multiples, taking
in cyclical industries in which market multiples vary over account of such differences in these value drivers is relevant
time depending on where the industry is in its cycle. Based for improving comparability when using certain earnings-
on historical measures of the denominator, multiples tend based or revenue multiples.
to be the highest when the industry is coming out of the Interestingly, while the enterprise value to EBITDA
trough of the cycle, and the lowest soon after it passes the multiple is perhaps the most popular multiple in practice,
peak of the cycle. For example, if we use current informa- it is likely to be significantly more sensitive to (and thus
tion to value a company when the industry is at the trough potentially more vulnerable to valuation differences caused
of its cycle, the market multiples we measure would reflect by) differences in value drivers than some other multiples,
the market multiples at the trough of the cycle. While like enterprise value to unlevered earnings. One potential
such multiples are appropriate for that valuation, for the explanation of its popularity may be that because EBITDA
continuing value calculation, we want to make sure that our is higher up in the income statement (closer to revenue), it is
valuation reflects the typical valuation of these companies. negative less often than either EBIT or unlevered earnings.
Thus, for our continuing value calculation, we probably However, in a valuation in which unlevered earnings for
want to estimate market multiples that reflect the midpoint the company being valued and the relevant comparable
of the cycle in conjunction with forecasts of the financial companies are positive and represent future growth and

36 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
Table 7 Year-by-Year Valuation and Market Multiples–Evolution of Market Multiples as a Firm Reaches Steady State

  ($ in millions )   Year -1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Income Statement
Revenue   $490.2 $500.0 $625.0 $750.0 $810.0 $826.2 $842.7 $859.6
Operating Expenses   -343.1 -350.0 -437.5 -525.0 -567.0 -578.3 -589.9 -601.7
Depreciation Expense   -16.3 -16.7 -20.8 -25.0 -27.0 -27.5 -28.1 -28.7
Interest Expense   -11.5 -12.8 -13.1 -14.3 -15.1 -15.5 -15.8 -16.1
Income Before Taxes   $119.2 $120.5 $153.6 $185.7 $200.9 $204.8 $208.9 $213.1
Income Tax Expense   -35.8 -36.2 -46.1 -55.7 -60.3 -61.4 -62.7 -63.9
Net Income   $83.4 $84.4 $107.5 $130.0 $140.6 $143.4 $146.2 $149.2

Balance Sheet
Net Working Capital   $98.0 $100.0 $125.0 $150.0 $162.0 $165.2 $168.5 $171.9
Property, Plant & Equipment (Net)   251.6 318.3 380.8 395.8 379.6 363.1 346.2 329.0
Total Assets   $349.7 $418.3 $505.8 $545.8 $541.6 $528.3 $514.8 $500.9
                    
Debt   $142.3 $145.2 $159.3 $168.0 $172.2 $175.6 $179.1 $182.7
Equity   207.3 273.1 346.5 377.8 369.4 352.7 335.7 318.3
Total Liabilities and Equities   $349.7 $418.3 $505.8 $545.8 $541.6 $528.3 $514.8 $500.9

Free Cash Flows

Earnings Before Interest and Taxes (EBIT) $133.3 $166.7 $200.0 $216.0 $220.3 $224.7 $229.2
- Income Taxes Paid on EBIT -40.0 -50.0 -60.0 -64.8 -66.1 -67.4 -68.8
Earnings Before Interest and After Taxes $93.3 $116.7 $140.0 $151.2 $154.2 $157.3 $160.5
+ Depreciation Expense    16.7 20.8 25.0 27.0 27.5 28.1 28.7
- Change in Net Working Capital -2.0 -25.0 -25.0 -12.0 -3.2 -3.3 -3.4
- Capital Expenditures -83.3 -83.3 -40.0 -10.8 -11.0 -11.2 -11.5
Unlevered Free Cash Flow    $24.7 $29.2 $100.0 $155.4 $167.5 $170.9 $174.3
- Interest Paid -12.8 -13.1 -14.3 -15.1 -15.5 -15.8 -16.1
+ Interest Tax Shield 3.8 3.9 4.3 4.5 4.6 4.7 4.8
+ Change in Debt Financing 2.8 14.1 8.7 4.2 3.4 3.5 3.6
Free Cash Flow to Common Equity   $18.6 $34.1 $98.7 $149.0 $160.1 $163.3 $166.6

                  CVFirm
  ($ in millions)     Year 1 Year 2 Year 3 Year 4 Year 5 Year 5
Unlevered Free Cash Flow for Continuing Value (CV) $174.3
Discount Factor for Continuing Value           10.277
End of Year Value Value of Firm $1,593.0 $1,679.9 $1,721.6 $1,756.0 $1,791
Unlevered Free Cash Flow 29.2 100.0 155.4 167.5 170.9
$1,622.2 $1,779.9 $1,877.0 $1,923.5 $1,962.0
Discount Factor 0.895 0.895 0.895 0.895 0.895  
Beginning of Year Value of Firm    $1,451.9 $1,593.0 $1,679.9 $1,721.6 $1,756.0 $1,791.1
Beginning of Year Value of Debt 145.2 159.3 168.0 172.2 175.6 179.1
Beginning of Year Value of Equity    $1,306.7 $1,433.7 $1,511.9 $1,549.4 $1,580.4 $1,612.0

        Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Annual Growth Rates
Revenue 2.0% 25.0% 20.0% 8.0% 2.0% 2.0%
Free Cash Flow 18.1% 242.9% 55.4% 7.8% 2.0%

Firm Value Market Multiples

Free Cash Flow Multiple 58.8 54.6 16.8 11.1 10.5 10.5
Unlevered Earnings Multiple 15.6 13.7 12.0 11.4 11.4 11.4
EBIT Multiple 10.9 9.6 8.4 8.0 8.0 8.0
EBITDA Multiple 9.7 8.5 7.5 7.1 7.1 7.1
Revenue (Sales) Multiple - Firm Value 2.9 2.5 2.2 2.1 2.1 2.1
Total Assets Multiple 3.5 3.1 3.1 3.2 3.3 3.5

Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 37
performance prospects as well or better than EBITDA, References
our findings suggest that the enterprise value to unlevered Alford, A., “The Effect of the Set of Comparable Companies
earnings multiple may be a more reliable measure to use in on the Accuracy of the Price-Earnings Valuation Method,”
a market multiple valuation. Journal of Accounting Research 30 (1992), pp: 94-108.
Banz, R. “The Relationship Between Return and Market
Values of Common Stock,” Journal of Financial Economics 9
Robert W. Holthausen is the Ernst and Young Professor and the (March, 1981), pp. 3-18.
Nomura Securities Professor of Accounting and Finance, as well as Chair Beatty, R., S. Riffe, and R. Thompson, “The Method of
of the Accounting Department, at the University of Pennsylvania’s Wharton Comparables and Tax Court Valuations of Private Firms: An
School of Business. Bob’s research has studied the effects of manage- Empirical Investigation,” Accounting Horizons (September,
ment compensation and governance structures on firm performance, the 1999), pp: 177-199.
effects of information on volume and prices, corporate restructuring and Fama, E. and K. French, “The Cross-Section of Expected
valuation, the effects of large block sales on common stock prices, and Stock Returns,” Journal of Finance 47 (1992), pp. 427-463.
numerous other topics. Keim, D. “Size-Related Anomalies and Stock Return
Seasonality: Further Evidence,” Journal of Financial Econom-
Mark E. Zmijewski is the Leon Carroll Marshall Professor of Account- ics 9 (June 1983), pp. 13-32.
ing at The University of Chicago’s Booth School of Business. The focus of
Mark’s extensive academic writings and consulting are issues related to
valuation, security analysis, and the effect of financial and other disclo-
sures on capital market participants and security prices.

38 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012
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