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In some situations the only completely objective value measure is the market capitalization This is equal to the number of outstanding shares of common stock times the market price per share, assuming the market price is observable and there are no complexities in computing the number of outstanding shares Any acquirer would have to expect to pay a premium to the current market capitalization The market value of the common stock sets a floor for an offering price by a buyer Rarely would a buyer consider submitting a bid less than current market price and expect to acquire a majority of the outstanding shares In fact, one would expect the acquirer to have to pay a premium over the market price Thus the market price of the common stock is an important measure of value since it sets a minimum-offering price It can be argued that, with a closely held corporation, if the stockholders desire to unload their stock, they may not be able to, because the market is too thin In such a situation the seller might accept the market price or even marginally less than the market price, since the market price does not fairly represent the firm's value Can one obtain the value of the stockholders' equity by using the market value for a few shares traded on the stock market It should be remembered that the entire universe of investors is available as possible purchasers of the stock and that the present owners are not bidding up the stock price to acquire more shares Normally it will not take a large price increase to cause the present investors to sell their shares of stock assuming the price before the bid was set by the market Premiums paid by the acquirers in most deals are less than 30
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The use of multipliers for valuation is common practice A multiplier is applied to some type of flow measure The multiplier is frequently based on the observed relationships of comparable firms The following multipliers are used:
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Price-earnings multiplier Cash flow multiplier (EBITDA and free cash flow multipliers) EBITDA is earnings before interest, taxes, depreciation, and amortization Free cash flow is cash flow from operations after maintenance capital expenditures Sometimes free cash flow is computed after all investment outlays Cash flow multipliers applied to the next period's flows (eg, NEBITDA) If one takes the current earnings and multiplies by the current price-earnings multiplier, one obtains the current market price The expected earnings of the current year or an adjusted earnings can be used rather than the observed earnings of the past year Another variation is to use the expected earnings of the next year The use of the expected earnings times a price-earnings multiplier is a common technique for evaluating prospective acquisitions It may be a shortcut method of applying discounted cash flows The following mathematical model illustrates this position
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The price-earnings ratio (P/E) that is expected is equal to the dividend payout rate (1 - b) divided by - g The larger the value of the growth rate (g), the larger the value of the P/E ratio that will be justified Assume the P/E of comparable firms is computed to be 8 and the earnings to the stockholders of the target firm are $10,000,000 The valuation of the stock is $80,000,000 But the following complexities exist: Were the other firms really comparable Were the earnings really $10,000,000 or should adjustments be made Does the firm have excess assets Does the firm have unrecorded liabilities Is there reason to expect that next year's earnings will differ sig nificantly from $10,000,000 Is the average P/E of 8 for comparable firms reasonable Instead of using an earnings multiplier many merchant bankers prefer to use a cash flow (or EBITDA or free cash flow) multiplier Again the multiplier is obtained from observing comparable firms Assume the cash flow (EBITDA) multiplier of comparable firms is 6 and the firm's cash flow (EBITDA) is $20,000,000 Now the firm's estimated value is $120,000,000 If the debt is $40,000,000 this value is consistent with the $80,000,000 value of the stockholders' position obtained previously The value normally obtained using EBITDA is the firm's value (debt plus equity) rather than the stockholders' value Now let us consider the average P/E of 8 for 10 comparable firms Assume that 9 firms have a P/E of 5 and one firm has a P/E of 35
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