Why cash flow is more important than multiples
When you read analysts’ reports, you’ll often see they use multiples to value and assess the prospects of a business. But this is not our preferred method. At Montgomery, we prefer to value businesses based on their expected cash flows. After all, using multiples does not explicitly consider the revenue and margin assumptions driving the value of the business.
The Montgomery Global team recently analysed a stock that was being pressured by an activist investor to split its business into two separate companies. The firm is comprised of a restaurants business, and a packaged foods business. The argument put forth was that the packaged foods business is deserving of a higher valuation multiple, and by remaining a part of the restaurants business its valuation multiple is being penalised by the market. Spinning off the packaged foods business could produce an upward multiple re-rate and unlock shareholder value.
There can be genuine benefits from splitting up companies, particularly if there are minimal synergies from keeping the two businesses together. A split could allow the management teams to pursue more focused strategies, or lead to better coverage from the sell side community (i.e., packaged foods analysts would be covering the standalone foods business rather than restaurants analysts trying to cover the combined entity when they may have little expertise in analysing packaged foods businesses).
However, using a multiples approach to justify the pro-forma valuation of the standalone entities is fraught with error.
The first difficulty involves choosing the valuation multiple for the analysis. Is a price-to-earnings (P/E) multiple appropriate? What about an enterprise value to earnings before interest, tax, depreciation, and amortisation multiple (EV/EBITDA)? The activist in the above example chose an EV/EBITDA multiple, one favoured by investment bankers when pitching transactions. However, EBITDA fails to account for the reinvestment needs of a business and it is not a metric the Montgomery team pays much attention to. What if the reinvestment needs, broadly encapsulated by the D&A number, are vastly different between the chosen companies?
In the above example, despite having the exact same EBIT as Company B, Company A appears to be more expensive on an EV/EBITDA multiple due to the fact that it doesn’t need to reinvest in its business. This is a nonsensical conclusion and it raises an important point around the comparability of these peer companies.
The activist used a number of restaurant peer companies to derive a 9x average EV/EBITDA multiple, and then a group of packaged foods businesses to calculate an average 14x EV/EBITDA multiple. This begs the question: are these companies truly comparable? We noted differences in the revenue growth prospects and margin profiles that may distort comparability. More concerning than the fundamental differences between these “comparable” businesses was their exorbitant valuations, a factor that could lead to an inflated value being ascribed to the packaged foods business that was being valued.
Just because these peer companies are trading at 14x EBITDA, an arguably very rich valuation multiple, it does not make it appropriate to use this multiple to calculate the intrinsic value of the packaged foods business. This analysis might signal the price the market is willing to pay at any point in time, but this follows the “greater fool theory” of what the next person is willing to pay for an asset, and it is not a theory we subscribe to.
The Montgomery team prefers to value businesses based on the cash flows they are expected to produce over their lifetime. The multiple upon which a stock trades is a function of the set of revenue and margin expectations baked into the stock price. Using multiples to value businesses is first level thinking and does not explicitly consider the revenue and margin assumptions that are truly driving the value of the business.