Many Business Valuers, Business Brokers, Auditors and Accountants value private businesses using the Price:Earnings (P/E) Multiple Method.
The question is, is this a fundamental business valuation method?
Furthermore, is this a valuation method that applies to the enterprise valuation computation or equity computation?
What is the P/E Multiple?
It represents the relationship and correlation between earnings (Net Profit After Tax) and the price of a share, i.e the capitalised value of the company, viz equity.
So for example, if the company’s earnings after tax is R100 000 and the share is trading at a value of R100 per share with 1 000 shares issued, the capitalised value is R1 000 000, the P/E Multiple is 10 to 1 (10.0).
Consequently, if one considers a private company’s performance in a particular sector, to be comparable with a listed company, where unlisted companies P/E ratio is 10, one would value the private company’s shares at the current latest NPAT and capitalise it at the P/E ratio of 10.
For example, NPAT latest year is R150 000 x 10 = R1 500 000 is the value of the shares (equity).
However, using the P/E Multiple to value any company has fundamental flaws.
- It is not a fundamental intrinsic valuation method – it simply represents the correlation or relationship between historical earnings (NPAT) and the market price based on the share price.
- It does not take into account the level of gearing (debt finance) on the Balance Sheet.
- It does not take into account the specific business risk of the business and impact on cost of risk.
- It makes no reference to projected earnings and the impact on a discounted valuation.
- It does not value the business (enterprise or firm) but goes straight into an equity valuation.
- In many listed companies, the share price changes dramatically in relation to announcements, which will result in dramatic changes in the P/E ratio, although the earnings may not have increased.
If two companies in the same industry achieves the same NPAT, although they have different Balance Sheets in relation to equity/gearing levels, using the same P/E Multiple for both businesses results in the same equity valuation, which is incorrect.
The P/E Multiple should not be used to calculate either the business value or the equity value of both private and public (including listed) companies.