Price to Earnings multiple

A price to earnings multiple asks one question. How many rupees does the market pay for each rupee a company earns?

Take the share price and divide it by the earnings per share. A share at Rs 160 with earnings of Rs 5 a share trades at a P/E of 32.

The workbook calls the P/E the most widely used market related multiple in valuation. It gauges the value of a company as a multiple of its current earning capacity.

There is a catch for an AIF. The price in the formula is a market price, and an unlisted company does not have one. So a fund cannot read a P/E off its own portfolio company.

It has to borrow the multiple from a listed peer — what the workbook calls a listed surrogate — and then cut it, because a share nobody can sell on a screen is worth less.

Where it sits (Chapter 11, section 11.7). Relative valuation uses standardised multiples so that firms can be compared and value benchmarked. The workbook splits the multiples in two:

Section 11.7.3, in full. The P/E multiple is used extensively to determine the market valuation of stocks in listed companies, because the price used in the metric is the current market price of the share. It can also be used sometimes to compare unlisted companies in the alternative space to their listed peers, to know the range at which they are being valued. That is the entire section, plus one illustration.

Illustration 11.8 — the examinable arithmetic. Alpha Ltd has after-tax profit of INR 100 lakh and paid-up capital of INR 200 lakh, being 20 lakh shares of INR 10 each. It trades at a P/E of 32.

EPS = 1,00,00,000 ÷ 20,00,000 = INR 5. Current market price = 32 × 5 = INR 160 per share.

Read the illustration backwards and it becomes the valuation use: apply a peer multiple to your company's EPS and you get a price.

The discount that separates the AIF use from the listed use (section 11.8.3). In the IPEV list, the multiples approach is described as commonly used for profit-making companies, with each multiple computed on historical, sustainable or projected data. It is usual to take comparable ratios from the quoted markets or from relevant recent transactions — and then normal to apply a discount to the quoted market ratio to reflect the illiquidity discount applicable to unlisted stock. The workbook adds that the discount may be reduced if a fund manager believes an exit to be imminent. It gives no percentage.

Why the multiple fails on a young company. Section 11.7 lists relative valuation's own weaknesses: it ignores future capital expenditure and incremental working capital; it suits only companies that have reached maturity and are stable in outlook; the selection of multiples is subjective; and multiples move with external factors even when nothing has changed inside the firm. Section 11.7.1 adds the specific case — where EBITDA is positive but profit after tax is negative, because of a heavy interest, depreciation and amortisation burden in a long-gestation or asset-heavy business, the EV/EBITDA multiple is the better measure of value. A negative PAT makes a P/E meaningless.

What the workbook reaches for instead. Immediately after section 11.7.3 it notes the PAT multiple (value of firm ÷ PAT) and the EBIT multiple (value of firm ÷ EBIT). For early-stage, technology and service businesses it turns to non-financial multiples: the GMV multiple in e-commerce, ARPU in telecom, and ARR, average room revenue, in hotels. Its closing point on the family is that the multiples approach is very useful to validate a valuation arrived at by a different approach, because it can be compared against peers, listed and unlisted, and against industry benchmarks.

Alpha Ltd and its figures are the workbook's own Illustration 11.8. The AIF, the portfolio company and the discount rates around it are illustrative — the workbook prescribes no discount percentage.

Step 1 — the workbook's arithmetic.

Step 2 — the same multiple run the other way, on an unlisted company. Mysuru Foods Pvt Ltd is a portfolio company of a Category II AIF. Being unlisted it has no market price at all. It earned profit after tax of Rs 24 crore on 4 crore shares, so its EPS is Rs 6. Two listed surrogates trade at P/Es of 30 and 26, an average of 28.

Indicated price per share = Rs 6 × 28 = Rs 168. Indicated equity value = 4 crore × Rs 168 = Rs 672 crore.

Step 3 — the illiquidity discount. Nobody can sell a Mysuru Foods share on a screen. Applying an illiquidity discount of 25%, an assumed rate:

Rs 168 × (1 − 0.25) = Rs 126 a share, or Rs 504 crore.

If the manager expects an IPO within the year, the workbook allows that discount to be reduced. At 10%:

Rs 168 × 0.90 = Rs 151.20 a share, or Rs 604.8 crore.

The company has not changed. Only the assumed nearness of an exit has, and on these figures it is worth about Rs 100 crore of reported value. That is why the discount is the contested number in any AIF valuation using a listed peer's P/E.

Step 4 — when the multiple stops working. A year later Mysuru Foods borrows heavily for a new plant. EBITDA holds at Rs 60 crore, but interest and depreciation push profit after tax to minus Rs 8 crore. The P/E cannot be computed at all — there is nothing sensible to divide a price by. The workbook's answer for exactly this case is the EV/EBITDA multiple, because EBITDA measures operational efficiency and survives a negative PAT.

Chapter 11, section 11.7.3 (Price to Earnings Multiple) with its Illustration 11.8, section 11.7 for where the multiple sits among trading comps and deal comps, and section 11.8.3 for the illiquidity discount on quoted ratios.

Expect the illustration itself as a calculation question — profit after tax, number of shares and a multiple, solve for the price; or price and EPS, solve for the multiple. Expect a classification question: is the P/E a trading comp or a deal comp? It is a trading comp, a market based multiple. And expect the AIF-specific point, which is the one a listed-markets candidate gets wrong: for unlisted companies trading comps are quite unsuitable, and at best the current market multiples of listed surrogates may be used.

• Two pages, and they are not the same page. P/E ratio is the listed-market page from the research papers, with the trailing, forward and current versions of the ratio and the PEG comparison. This page is Series XIX-D's: the same arithmetic, used by an AIF on an unlisted portfolio company through a listed surrogate and an illiquidity discount. A question about a Nifty stock's P/E belongs to the other page; a question about valuing a portfolio company belongs to this one.
• The price is a market price. An unlisted company has none, so a P/E cannot be read off it directly — only borrowed from a listed peer.
• Apply the discount to the quoted ratio. The workbook says it is normal to do so, and that the discount may be reduced if an exit is imminent. It gives no percentage, so any figure in an answer option is not from XIX-D.
• Negative earnings kill it. Where PAT is negative but EBITDA positive, the workbook sends you to EV/EBITDA. And where book value has gone negative — its own start-up case, in which accumulated losses wipe out the reserves and erode even the nominal value of the subscribed capital — the price to book value multiple cannot be used either.
• P/E is a trading comp, not a deal comp. Deal comps are the earnings based transaction multiples: EV/EBITDA and EV/Sales.
• ARR means two different things in this workbook. In section 11.7's non-financial multiples it is the hotel industry's average room revenue. In section 11.8.1's start-up metrics it is annual recurring revenue. Read the section, not the abbreviation.
• A wording tension inside section 11.7. The section states that relative valuation methods determine the Enterprise value, and that the book or market value of outstanding debt must be deducted to reach equity value. It says this in the sentence introducing the firm value multiples it is about to discuss. The P/E, by contrast, is built from a share price and earnings per share, both equity figures. Read the enterprise-value sentence as belonging to the firm value multiples, and do not deduct debt from a price per share derived from a P/E.
• A multiple validates; it does not replace. The workbook's own use for the family is to check a valuation reached by another approach against peers and industry benchmarks.