Valuing a business based on exit multiple is straightforward in theory, it requires you to understand the Industry, Company prospects and estimate their future plans to get a rough estimate of the company’s revenue & margins at the end of let's say 3 or 5 years and then some simple mathematics is required. Lets see an example
So why a blogpost on such seemingly easy topic? While the concept of valuing a company using exit multiples is simple in our limited experience we have seen people just copy-pasting the past few year median revenue growth rate, median margin, median P/E and/or EV/EBITDA multiples (as Exit multiples) to value the company.
While logical ways of forecasting revenue and margins will be explained by us in a separate series under the Business Analysis section, we have decided to attribute this post to the mistakes we shouldn’t make while valuing our company through exit-multiple relative methods.
Let us go deep into the first method in this post i.e. Historical Multiple method under Relative Method.
Mistakes we should avoid in taking our own company’s historical multiples:
a. If Growth has changed then forget about past multiple - ITC
So before taking historical P/E of a company just do a random check on screener, Check company’s historical growth and it’s historical P/E and try to understand what P/E company was getting on it’s historical growth.
The above snapshot is the P/E of ITC since 2007.
Median PE = 30.7
Current PE = Approx 20 (as on date 7/10/2021)
Using past median P/E as an exit multiple will be a wrong activity if future expected growth and historical growth of selected period turns out to be drastically different.
For example, ITC was getting P/E of 35 to 40 when it was growing it's revenue in double digits. But after 2015 the company's growth rate has turned to be well below historical growth rate and majority of the years in low single digits. See below image for historical growth rates
Hence an analyst expecting ITC to get same Exit P/E of 30-35 when the company’s growth is on a completely different trajectory as compared to the past will end up:
1- Taking a much higher expected terminal value
2- In effect leading to a higher current intrinsic value.
Still the world is full of surprises and if ITC returns back to its glorious period of double digit growth rate while maintaining the ROEs (basically turnarounds from here) the market may again assign ITC a Multiple of 30-35. In short, an analyst will have to be careful regarding his future expectation of growth vs historical growth of the company.
Even though you believe ITC will remain at this level of PE in near future there can be multiple reasons for buying something depending on investor's nature - some may feel ITC is available at excellent dividend yield with downside protection, it's a deep value buy, market is pricing in a no growth scenario etc. We will also be explaining all such angles of valuations in the Valuation Series later on.
b. Peak ROE, Peak Margins and peak Multiples - Avanti Feeds
So imagine you are analyzing Avanti feeds in 2017/18 and to calculate intrinsic value of avanti you decided to take Exit multiple as the same multiple which it was trading at that time i.e. current PE at the time of 2017/2018 which was in range of 25-30X earnings.
In short you were taking the Peak Multiple of company as Exit multiple. In other words you expected the company to maintain the current margins & current revenue growth rate & hence expected the market to assign Avanti the same multiple even 3-4 years down the line i.e. around 2021/22. Lets look at what exactly happened to the P/E multiple after 2017/2018 and try to understand that in alignment with revenue growth rate & margins of the company.
So above attached is the consolidated P&L of Avanti feeds. At the time of assuming an exit multiple on future profits/cash flows you need to have clarity of one thing which is “Historically Market has offered what multiple on what growth, on what margin and on what ROE/ROCE/ROIC levels”.
If you observe the pattern correctly you will find that the market has given Avanti feeds multiple of 25-35 when it was having sales growth more than 30% with an operating margin of 12-13% whereas the Median margins of the company are approximately 10% & median PE of 16-17.
1- There is a gap in the above snapshot. It means the company has made a loss for that number of years that’s why P/E would be 0 at that time.
2- During 2013 even though company growth & margin were rock solid you might see P/E into 5-10 range as it was one of the most severe bear market in India where valuations basically completely disconnected from business performance as there was panic selling all around.
Hence taking a future exit multiple we need to clear about future growth rates & margins alignment with the PE. Be carefully especially in Cyclical stocks which trades at ultra high P/E at the start of an upcycle - some analyst may take those high P/E as exit P/E's 3-5 years down the line whereas P/E of such companies will be hammered down drastically once down cycle starts. Hence at lower profits you will also get lower P/E - a negative lollapalooza effect. See for example the P/E chart of Hindustan Copper or TATA Steel.
Tata Steel P/E chart
Hindustan Copper P/E chart
c) Company business segments have evolved - P I Industries & Rossell India
So another thing to keep in mind while taking historical multiples should be whether a company has changed it’s segments? If yes then you can not take its historical multiple. To understand this we will use 2 examples, 1st of P I Industries which changed it’s segment but that new segment was in the same industry and 2nd of Rossell India, which diversified into different industries altogether.
So imagine an analyst analyzing P I Industries in 2013-14, The average P/E of that company before 2014 was around 20 when the company’s major segment was Domestic Agrochemical market. But what happened after 2013 is they started increasing contributions from the CSM segment within the same industry which was high margin business (Custom Synthesis and Manufacturing). Hence if you see Margins of the company you will find a big movement in that over the years. In 2018-19 the major revenues are coming from CSM segment. Apart from being a high margin business CSM is a better business model in terms of Longevity, Stability, IP orientation, entry barriers etc.
Chart - Margins
Chart - P/E Ratio
So as the company's main revenues started coming through high margin & better unit economics business P/E of the company got Re-rated during the time.
Basically the Company isn't the same as it used to be, so how can we take the historical multiple of a company to value it today? What you can do in this case is you can find another company who is into these segments and try to get an idea what multiple companies might get in future.
Please check below our primary calculations/Data gathering for revenue break, Margins calculations through management con-call commentary & Annual Reports:
Note: Above image 2020 Revenue breakup source
So you might think why we have taken 70% export business revenue as CSM revenue right. So in 2011 Con-call company has given this disclosure shown in below's snapshot.
So now as we have seen company's Revenue bifurcation from different segment now let us see margins of both the segments and then understand the reason of P/E rerating.
Now let us look at the second company Rossell India who is cultivating tea and is also in aviation. This company in 2021 discontinued one of it’s operations i.e. Food and beverage shown in the snapshot below.
Both segments i.e. Tea and Avionics currently contribute almost 50% to their revenue so what do you think what multiple this company would be getting? So here is the snapshot of this company's revenue bifurcation from their annual report.
In such scenarios we value the companies by SOTP (Some of total part pricing). In SOTP pricing you need to sit and understand both the segments of the company and try to forecast their revenue and margin differently. So below is a dummy example of how you take an estimate of exit multiple.
So as you can see from the above image the total market cap of the company is 850 but as it’s a conglomerate so it will get a conglomerate discount of 20-25%. 25% is not derived from anywhere but this is an historical pattern observed.
That's why Mr. Warren Buffett has said that “Demergers unlocks Value”. So whenever you are analyzing an conglomerate and want to take their exit multiple then you have to do just 2 things:
Apply Conglomerate Discount.
Also Read our summary of brilliant work on holding company discounts done by Amit Mantri and Savi Jain of 2 Point 2 Capital.