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Meditari Accountancy Research

The use of multiples in the South African equity market: is the popularity of the price earnings ratio
justifiable from a sector perspective?
W.S. Nel

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W.S. Nel, (2009),"The use of multiples in the South African equity market: is the popularity of the price earnings ratio
justifiable from a sector perspective?", Meditari Accountancy Research, Vol. 17 Iss 2 pp. 101 - 115
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The use of multiples in the South African equity


market: is the popularity of the price earnings
ratio justifiable from a sector perspective?

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WS Nel
Department of Accounting
University of Stellenbosch
Abstract
The price earnings (P/E) ratio is generally regarded as the most popular multiple used
to value equity in practice. Although this is supported by evidence from practice, the
use of the P/E ratio has not been substantiated by evidence from research. This article
investigates the accuracy of the five most popular multiples, including the P/E ratio,
in valuing the equity of South African companies listed on the JSE Securities
Exchange, for the period 1988 to 2007. The research results revealed that the P/E
ratio does not perform the most accurate valuations across all sectors and that
different multiples should be used for different sectors. There is an opportunity to
enhance the accuracy of equity valuations based on multiples by employing multiples
other than the P/E ratio.
Key words
Equity valuation
Multiples
Price earnings ratio
Valuation errors

1 Introduction
It is generally held that multiples are not suitable primary valuation techniques and that
they should ideally be used to supplement more acceptable, comprehensive valuation
techniques such as the free cash flow model. This approach was confirmed by Courteau,
Kao, OKeefe and Richardson (2003:24), who indicated that valuations based on multiples
perform less accurate valuations than more sophisticated alternatives. The results of a
survey conducted by PricewaterhouseCoopers (PwC 2008:13) revealed that the discounted
cash flow technique is used more frequently than market-based techniques such as the price
earnings (P/E) ratio. While multiples are used extensively in practice, usually in
conjunction with other models, there seems to be limited empirical work available to
provide guidance on which multiples best suit different sectors in South Africa. Although
there is ample research on equity valuation internationally, this appears not to be the case in
emerging markets (Bruner, Conroy, Estrada, Kritzman & Li 2002:311).
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Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

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In this study, the five most popular multiples currently used in South Africa will be used
to calculate the equity value of companies listed on the JSE Securities Exchange, in order to
ascertain how well they approximate actual share values. The total population for all the
multiples includes 15 650 observations, spanning 24 sectors, for the period 1988 to 2007.
Section 2 states the objectives of the research, followed by the evidence from research
and practice regarding multiples in section 3. Data selection is covered in section 4. In
section 5, the research methodology is discussed, including the mathematical definition of
the concept of valuation errors, which serves as the premise for the research. The results of
the research are presented in section 6, where the evidence is compared with current
practice in South Africa. Concluding remarks are offered in the final section.

2 Objectives of the research


The primary aim of this article is to establish whether research supports analysts
preference for the use of the P/E ratio as a market-based approach to equity valuations, as
indicated by the PwC survey (2008:41). Technically, the most appropriate multiples for any
sector will be those with the tightest distribution around the mean, that is, those with the
lowest dispersion or the tightest range (Pratt 2006:4). To this end, the mean, median,
standard deviation, variation coefficient and various dispersion ranges will be calculated in
order to identify the multiples with the tightest dispersion for each sector.
The secondary aim of this article is to determine which multiples that are currently most
popular in practice may be more appropriate in other words, present a more accurate
equity valuation for different sectors. The five multiples selected for this purpose are the
top five multiples as per the PwC survey, namely the P/E ratio, market value of invested
1
capital (MVIC) /earnings before interest, tax, depreciation and amortisation (EBITDA),
MVIC/earnings before interest and tax (EBIT), price/book value of equity (P/BVE) and
price/profit before tax (P/PBT).

3 Evidence from research and practice


Equity valuation techniques based on multiples usually have broad dispersions (Fernndes
2001:2), which is why valuations based on multiples are not generally regarded as the
purest equity valuation models. While multiples may not be the purest approach to
determine a companys equity value, in practice they are used as value indicators in
conjunction with a more conceptually sound approach. Equity valuations of unlisted entities
performed by means of multiples usually require the identification of an appropriate
benchmark multiple. Most research builds on the comparable company principle work of
Alford (1992:103), who found that the matching of past growth within a sector improves
the performance of multiples. Although research conducted by Berkman, Bradhury and
Ferguson (2000:82) in New Zealand presents evidence to the contrary, their evidence was
based on data that were difficult to obtain in a thinly traded capital market, which may have
obscured their results.

102

MVIC = market capitalisation + preference shares + interest-bearing debt

Meditari Accountancy Research Vol. 17 No. 2 2009 : 101-115

Nel

3.1 Sector multiples


According to Goedhart, Koller and Wessels (2005:1), many analysts calculate a sector
average multiple and multiply it by a specific companys earnings to value the companys
equity. The starting point is usually the identification of a benchmark multiple of a similar
listed company in the same sector, or calculating the average of that multiple for the sector
in which the company operates. Russian researchers Ivashkovskaya and Kuznetsov
(2007:46) investigated the option of seeking comparable companies in developed countries.
They compared various Russian multiples with those of the USA and found that using
comparable across-border multiples led to a significant overvaluation of equity.

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3.2 Value drivers


Although empirical work on multiples in emerging markets is limited, a number of
international researchers have conducted empirical research on multiples and value drivers
in particular. The debate on the main value drivers seems to focus on earnings and cash
flows. Liu, Nissim and Thomas (2002:23) found earnings to be the best value driver in
valuing equity. They focused on price multiples and investigated which value drivers
performed the best amongst earnings, cash flows, dividends and revenue, to approximate
stock prices in ten countries, including South Africa. They found that multiples based on
earnings generally performed the best valuations, while those based on cash flows and
dividends produced average results. Multiples based on revenue performed the worst.
Cheng and McNamara (2000:367) found similar results in a study of the valuation accuracy
of the P/E and the P/BVE ratios as benchmarks between 1973 and 1992. Their research
indicated that earnings was the most important value driver. Volker and Richter (2003:216)
drew a similar conclusion.
A number of researchers have refined their research to determine which earnings-based
value drivers are superior to others. Baker and Ruback (1999:19) compared EBITDA, EBIT
and revenue as value drivers and found that sector-adjusted EBITDA outperformed EBIT
and revenue. Lie and Lie (2002:53) came to the same conclusion, finding EBITDA to be a
more accurate value driver than EBIT, and that forward-looking multiples outperformed
historical multiples. The latter was confirmed by Kim and Ritter (1999:430), who
concluded that two-year earnings per share (EPS) forecasts outperformed one-year
forecasts, while one-year EPS forecasts again dominated current EPS, in terms of the
accuracy of forecasts. In keeping with this research, Schreiner and Spremann (2007:18)
came to the conclusion that forward-looking multiples performed more accurate valuations
than trailing multiples. They discovered that the superiority of forward multiples depended
largely on the choice of the value driver.

3.3 The popularity of the P/E ratio


Research on specific multiples has largely focused on price multiples, which typically
includes a discussion of the P/E ratio. Since the general perception is that the P/E ratio is
the preferred multiple in equity valuations, executives may try to orchestrate a high P/E
ratio (Chadda, McNish & Rehm 2004:12). In a survey conducted in the UK, Barker
(1999:414) found that, although the P/E ratio is the primary multiple used by analysts, this
is not the case across all sectors. The survey results indicated that the dividend yield
surpassed the P/E ratio in the utilities and financial sectors, for example. Does this hold true
for South Africa as well, or is the P/E ratio the most appropriate multiple across all sectors?
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103

Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

3.4 The five most popular multiples used in practice in South


Africa

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The use of multiples is based on judgments about the worth of an asset compared to what
the market is willing to pay for similar assets (Damodaran 2007:59). This would imply that
there is a large degree of trust in the market for determining accurate valuations, at least on
average.
Figure 1 indicates the results of a biennual survey launched by PwC (2008:41). The
survey results confirmed that the P/E ratio is indeed the most popular multiple used in
practice in South Africa, while the MVIC/EBITDA multiple is a close second choice,
followed by the MVIC/EBIT ratio, P/BVE and P/PBT.
Figure 1 Multiples that are used most frequently in practice in South Africa
MVIC/Revenue
P/CFO
Other
P/CF
P/PBT
P/BVE
MVIC/EBIT
MVIC/EBITDA
P/E ratio
-

0.50

1.00

1.50

2.00

2.50

MVIC - market value of invested capital; P/CFO - price/cash flow from operations; P/CF - price/earnings
plus non-cash charges; P/BVE - price/book value of equity; EBIT - earnings before interest and tax;
EBITDA - earnings before interest, tax, depreciation and amortisation; P/E - price/earnings
Source: PwC (2008:41) 2

Although practice seems to place the P/E ratio on a pedestal, there is little evidence from
research to support this. The superiority of the P/E ratio as a value indicator has not been
substantiated by research, especially not on a sector-specific basis. Popular belief suggests
that different sectors have different best multiples (Liu, Nissim & Thomas 2001:135). In
a study conducted on UK and European sectors, Fernndez (2001:6) found that analysts
have a preference for certain multiples in certain sectors, which supports the notion that
different multiples are suited to different sectors. A similar conclusion was drawn by
Abukari, Jog and McConomy (2000:18) in a study of equity valuation techniques based on
companies listed on the Toronto Stock Exchange.
2

104

The 2007 PwC survey had 25 respondents. The survey used a frequency table between 0-3, where 0
indicated that the multiple is seldom or never used, 1 indicated that the multiple is often used, 2
indicated the multiple is frequently used and 3 indicated that the multiple is always used.

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Nel

Four of the five multiples that form the focus of this article, the P/E ratio,
MVIC/EBITDA, MVIC/EBIT and P/PBT, are based on earnings, while P/BVE is based on
book value. The main point of criticism regarding these multiples is that they are based on
accounting measures, which may be manipulated. These accounting measures, in turn, rest
on accounting rules and principles, which may be applied differently by different
companies.
The inherent flaw in the five most popular multiples is that their value drivers are based
on historical figures, that is, there is an underlying assumption that history is bound to
repeat itself. However, the purpose of an equity valuation is to determine the equitys
worth, which by definition, should be equal to the present value of an assets future
earnings potential.
The P/E ratio and the P/PBT ratio are susceptible to changes in the capital structure. An
all-equity company can, for example, artificially increase these multiples by increasing its
leverage (Goedhart et al. 2005:1). Although the MVIC/EBITDA and MVIC/EBIT multiples
may prove less susceptible to this kind of manipulation, since they include both equity and
debt, they also include operating leases, which are non-operating items. Consequently,
companies with significant operating leases may have an artificially low MVIC, assuming
that the value of lease-based debt is ignored, and an artificially low EBITDA, since rental
payments include interest charges. Other limitations include the fact that EBITDA and
EBIT neglect to take changes in working capital requirements into account and do not
consider capital investments (Stumpp 2000:1).
Apart from book value, which is affected by the accounting treatment of items such as
depreciation, the P/BVE has little relevance for companies with limited tangible assets,
such as technology companies (Damodaran 2002:511).

4 Data selection
The following variables were extracted from the McGregor BFA database: market price of
shares, preference shares, volume of ordinary shares, interest-bearing debt, headline
earnings per share, depreciation, earnings before interest and tax (EBIT), profit before tax
(PBT), ordinary shareholders interest and sector.
The companies were selected on the basis of three criteria: (1) all multiples are positive,
that is, multiples with negative values were discarded; (2) the companies have at least three
3
years of positive company year multiples; and (3) each sector has at least four observations
that meet criteria (1) and (2) above. The first condition eliminates unrealistic multiples that
cannot be used. The second condition ensures that selected companies have a reasonable
history as a going concern, and the third ensures that the number of companies within each
sector is not unnecessarily small, preventing the situation where there are too few
observations to warrant a realistic mean calculation. The final population of observations
represents approximately 65% of the total number of listed companies on the JSE as at
31 December 2007 and approximately 82% of the market capitalisation of the companies
3

The McGregor BFA sector classifications are super sector, sector, sub sector and industry. The sector
classification was used for the purpose of this analysis in order to ensure a sufficient number of
companies within each classification. Many companies sector classifications have changed over the
past 20 years. However, for the purpose of this analysis, companies were allocated to the sectors where
they resided as at 31 December 2007.

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Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

listed on the JSE at the same date, which serves as a fair representation for the conclusions
drawn.
The number of observations was different for each multiple, depending on how well the
variables compared to the criteria stipulated above. As a result, the multiples have different
population sizes, varying between 2 902 and 3 534 observations. The total population for
all the multiples includes 15 650 observations, which covered 24 sectors for the period
1988 to 2007. Although the BFA McGregor database provides information for companies
dating back to 1976, the earlier years are not well documented. Information for the years
between 1976 and 1987 was not readily available on the McGregor BFA database hence
the years 1976 to 1987 were discarded.
The data were used to calculate the P/E ratio, MVIC/EBITDA, MVIC/EBIT, P/BVE and
P/PBT. Although the calculation of MVIC requires the inclusion of interest-bearing debt at
market value, this information is not readily available on the McGregor BFA database
hence the use of the book value of interest-bearing debt as a proxy. EBITDA was calculated
by adding back depreciation to EBIT, since amortisation is included in depreciation on the
BFA McGregor database.
Research indicates that multiple value drivers based on earnings perform more accurate
valuations than those based on cash flows (Liu et al. 2002:23). Consequently, apart from
P/BVE, this article focuses on multiples with earnings-based value drivers. Although
P/BVE does not contain an earnings-based value driver, the PwC survey results indicated
that it is preferred over P/PBT hence its inclusion in the analysis.

5 Research methodology
Valuations based on multiples assume that the actual value (V) of a company (j) at a given
point in time (t) is equal to the product of a specific multiple () and a specific value driver
() at that specific point in time, so that
Vjt = tjt

(1)

The aim of this research is to establish the ability of valuations based on equation (1) to
approximate actual share values. The focus is on different sectors in South Africa and
which multiples best suit each of these sectors. The methodology is the following: First, the
data, as stipulated in section 4, are extracted from the McGregor BFA database and deflated
by the average annual CPI (with 2000 as basis year) to facilitate the use of data over a wide
spectrum of years. The data are then screened according to the criteria stipulated in section
4, and observations outside of the 1st and 99th percentiles are removed from the pool of
observations.
Next, an estimated sector multiple ([t]) is calculated for each company by calculating
4
the harmonic mean of all the other remaining companies in the sector concerned for that
4

106

There seems to be a lack of consensus in academic research regarding the use of the median, arithmetic
mean or the harmonic mean as averaging procedures (Dittman & Maug 2008:2). The harmonic mean is
preferred to estimate sector multiples since several researchers argue that it avoids the upward bias of
the arithmetic mean. Baker and Ruback (1999:17) suggest that, empirically, it is closer to the minimum
variance estimates deduced from Monte Carlo simulations than the simple mean, median or valueweighted mean. Liu et al. (2002:6) regard the harmonic mean as a viable and unbiased estimator, while
Beatty, Riffe and Thompson (1999:182) and Bhojraj and Lee (2002:416) also prefer to use the
harmonic mean.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 101-115

Nel

specific multiple. The estimated sector P/E ratio for company A, for example, in a sector
that contains companies A to E, will be equal to the harmonic mean of the P/E ratios of
companies B to E. Although it may seem necessary to pursue a more diligent selection
process by also considering factors such as company size and expected growth rates,
research has indicated that these additional factors do not significantly reduce valuation
errors (Alford 1992:96).
The estimated multiple of each company ([t]), that is, the harmonic mean of the P/E
ratios for companies B to E, is then multiplied by the companys actual value driver (j),
that is, company As earnings, to calculate a value indicator (Vi) of the companys shares:

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Vijt =[t]jt

(2)

Subtracting equation (2) from equation (1) produces equation (3) for the calculation of ,
the error margin (valuation error):
jt = Vjt - Vijt

(3)

The deviation jt is expressed proportionally to Vjt, therefore


Vjt - Vijt
jt =

Vjt
(4)

The valuation errors are calculated for each company year. Absolute valuation errors are
used since the results of dispersion measures such as the mean will be obscured if positive
and negative valuation errors are allowed to be netted. This may result in an artificially
narrow dispersion. After calculating the absolute valuation errors for each multiple and
excluding the observations that fall outside the 1st and 99th percentiles, the interpercentile
range (IPR) is calculated for each sector as a measure of the dispersion of the pool of
valuation errors. Comparing the IPR of each of the multiples allows for the comparison of
the five multiples per sector in an attempt to establish which multiples may be more suited
to a specific sector.
The multiples are then collated in a multiples value chain (MVC), ranking the multiples
from the widest to the narrowest dispersion per sector. The MVC indicates the potential
valuation performance enhancement as a percentage improvement (IMP) that could be
secured by choosing a multiple that performs a more accurate equity valuation, that is,
moving to a column further to the right on the MVC, and is calculated as
IMP =

IPR2-IPR1
IPR2

The multiples that are preferred in practice, as obtained from the PwC survey, are then
plotted on the MVC to identify an optimisation gap, that is, the gap between those multiples
that are preferred in practice and those with the narrowest dispersion of valuation errors.
The optimisation gap is calculated as a potential IMP in the valuation performance within a
certain sector by replacing the most popular multiple with the multiple with the lowest
dispersion.

6 Results
This section deals with the dispersion of valuation errors of the five most popular multiples
across various sectors. The measure used to calculate the dispersion of valuation errors is
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Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

the IPR. Table 1 contains the results of the IPR calculated for each sector multiple. The 5%
to 95% IPR was used as a measure of dispersion, since it eliminates the major outliers
without rendering the size of the pool of observations unnecessarily small. The valuation
errors, however, were also tested for the range 10% to 90%, the interquartile range, the
mean, median, standard deviation and variation coefficient, and all rendered similar
qualitative results. The P/E ratio is the multiple with the narrowest dispersion for between
25% and 50% of the sectors. Its position as a preferred multiple over various sectors
declines as the range approaches the interquartile range.
Although Table 1 indicates that the P/E ratio has the lowest average dispersion across the
24 sectors (1.56), this is not the case for each specific sector. If each sector is considered
separately, the P/E ratio has the lowest sector dispersion for only eight of the 24 industries,
that is, in 33% of the sectors, followed by MVIC/EBITDA (25%), MVIC/EBIT (21%) and
P/BVE (17%), while P/PBT seems to be the best alternative in only 4% of the sectors. In all
the other sectors there is an opportunity to enhance the valuation performance by utilising
another multiple.
Table 1

Interpercentile ranges for different sector multiples


P/E

Sector
Automobiles & Parts
Banks
Chemicals
Construction & Materials
Electronic & Electrical Equipment
Equity Investment Instruments
Food & Drug Retailers
Food Producers
General Financial
General Industrials
General Retailers
Industrial Engineering
Industrial Metals
Industrial Transportation
Life Insurance
Media
Mining
Nonlife Insurance
Personal Goods
Real Estate
Software & Computer Services
Support Services
Technology & Hardware
Travel & Leisure
Total

MVIC/EBIT

P/BVE

P/PBT

IPR

IPR

IPR

IPR

63
117
77
178
116
99
58
182
183
120
235
95
59
116
71
84
319
70
65
259
148
139
28
127

1.48
0.82
1.35
1.09
1.34
2.60
1.00
0.95
1.91
1.97
1.06
1.44
2.35
1.89
1.53
1.10
1.70
1.04
3.57
0.92
1.67
2.04
1.31
1.31

69
108
78
190
130
96
57
181
172
122
239
111
63
122
67
79
362
71
68
304
131
149
28
136

1.45
1.04
0.91
1.17
2.69
2.73
0.95
0.93
2.28
1.17
1.72
1.79
1.89
2.12
1.95
1.56
1.76
1.16
2.63
1.21
1.29
1.38
3.26
1.17

68
111
78
185
121
96
57
182
169
121
238
109
61
121
67
77
351
69
66
301
127
145
28
125

1.93
1.55
0.93
1.05
2.52
2.76
0.89
0.89
2.42
1.35
1.54
1.79
2.39
1.70
1.91
1.66
1.80
0.97
2.49
1.31
1.54
1.49
3.01
1.09

63
121
79
201
141
120
55
203
236
126
251
113
70
128
71
95
500
79
68
286
172
158
36
162

1.99
1.43
2.31
1.54
2.54
1.45
2.32
1.53
2.61
1.79
1.68
2.09
2.72
2.81
1.05
1.97
2.57
0.77
1.93
2.37
2.11
1.71
3.96
2.36

66
2.33
0.76
112
75
1.54
174
1.23
117 3.20
89
3.37
57
1.69
175
0.97
170
2.36
117
1.61
227
1.48
100
1.62
54
2.75
110
2.18
62
1.98
74
1.79
338
1.97
70
1.22
64
3.74
241
2.09
128
1.41
138
2.23
27
1.54
117
1.23

3008

3133

Average
Best performance: Number of
sectors

MVIC/EBITDA

3073

1.56
8

3534

1.68
6

2902

1.71
5

IPR

2.07
4

1.93
1

P/E - price earnings; MVIC - market value of invested capital; EBITDA - earnings before interest, tax, depreciation and
amortisation; EBIT - earnings before interest and tax; P/BVE - price/book value of equity, P/PBT - price/profit before
tax, N - number of observations; IPR - interpercentile range

108

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In Table 2, the IPR calculations from Table 1 are ranked from worst (IPR5) to best (IPR1)
performance across 24 sectors, that is, from the widest to the narrowest dispersion. Column
IPR1 contains the multiples with the best valuation performance for each sector. Although
favoured in practice as the multiple of choice, the results clearly indicate that the P/E ratio
is not the best alternative across all sectors. The percentage potential improvement (IMP) is
shown for each move to an alternative multiple situated one column further to the right. In
the automobiles and parts sector, for example, moving from the P/E ratio (situated in
column IPR2) to MVIC/EBITDA (situated in column IPR1) may secure a 3% IMP.
Table 2

Multiples value chain: multiples ranked from the widest to the narrowest
dispersion per sector

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Ranked multiple
IRP5
Sector
Automobiles & Parts
Banks
Chemicals
Construction & Materials
Electronic & Electrical
Equipment
Equity Investment Instruments
Food & Drug Retailers
Food Producers
General Financial
General Industrials
General Retailers
Industrial Engineering
Industrial Metals
Industrial Transportation
Life Insurance
Media
Mining
Nonlife Insurance
Personal Goods
Real Estate
Software & Computer Services
Support Services
Technology & Hardware
Travel & Leisure
Average

IMP

IRP4

IMP

IRP3

IMP

IRP2

IMP

IRP1

P/PBT
MVIC/EBIT
P/BVE
P/BVE

14%
8%
33%
20%

P/BVE
P/BVE
P/PBT
P/PBT

3%
27%
13%
5%

MVIC/EBIT
MVIC/EBITDA
P/E
MVIC/EBITDA

23%
21%
31%
7%

P/E
P/E
MVIC/EBIT
P/E

3%
8%
2%
4%

MVIC/EBITDA
P/PBT
MVIC/EBITDA
MVIC/EBIT

P/PBT
P/PBT
P/BVE
P/BVE
P/BVE
P/E
MVIC/EBITDA
P/BVE
P/PBT
P/BVE
P/PBT
P/BVE
P/BVE
P/PBT
P/PBT
P/BVE
P/BVE
P/PBT
P/BVE
P/BVE

16%
18%
27%
37%
7%
9%
2%
14%
1%
22%
2%
10%
23%
5%
5%
12%
21%
9%
18%
45%

MVIC/EBITDA
MVIC/EBIT
P/PBT
P/PBT
MVIC/EBIT
P/BVE
P/BVE
MVIC/EBITDA
P/BVE
P/PBT
MVIC/EBITDA
P/PBT
P/PBT
MVIC/EBITDA
P/E
P/PBT
P/E
P/E
MVIC/EBITDA
P/E

6%
1%
41%
2%
3%
10%
9%
0%
12%
3%
2%
7%
9%
10%
26%
37%
8%
16%
8%
6%

P/BVE
MVIC/EBITDA
P/E
P/E
P/PBT
P/PBT
MVIC/EBIT
MVIC/EBIT
MVIC/EBIT
MVIC/EBITDA
MVIC/EBIT
MVIC/EBIT
MVIC/EBIT
P/E
MVIC/EBITDA
MVIC/EBIT
MVIC/EBIT
P/BVE
MVIC/EBIT
P/PBT

1%
4%
5%
2%
3%
17%
4%
9%
1%
11%
20%
6%
2%
7%
5%
8%
8%
13%
49%
5%

MVIC/EBIT
P/E
MVIC/EBITDA
MVIC/EBITDA
MVIC/EBITDA
MVIC/EBIT
P/PBT
P/PBT
P/E
P/E
P/E
MVIC/EBITDA
MVIC/EBITDA
MVIC/EBIT
MVIC/EBIT
MVIC/EBITDA
P/PBT
MVIC/EBIT
P/PBT
MVIC/EBITDA

47%
44%
7%
4%
16%
13%
28%
11%
20%
10%
31%
30%
3%
21%
22%
24%
9%
7%
15%
7%

P/E
P/BVE
MVIC/EBIT
MVIC/EBIT
P/E
MVIC/EBITDA
P/E
P/E
MVIC/EBITDA
MVIC/EBIT
P/BVE
P/E
P/E
P/BVE
P/BVE
P/E
MVIC/EBITDA
MVIC/EBITDA
P/E
MVIC/EBIT

16%

11%

11%

16%

MVC - multiples value chain; IPR5-1 - interpercentile ranges ordered from the widest (IPR5) to the narrowest (IPR1)
dispersion; IMP - percentage potential improvement; P/E - price earnings; MVIC - market value of invested capital;
EBITDA - earnings before interest, tax, depreciation and amortisation; EBIT - earnings before interest and tax; P/BVE price/book value of equity; P/PBT - price/profit before tax

The discussion of the results will focus on each multiples best valuation performance. For
each sector, the actual multiple of choice that is applied in practice, that is, the P/E ratio, is
compared with the multiple with the best valuation performance in that particular sector.
The former will be based on the results of the PwC survey, while the latter will be based on
the results of the IPR calculated for each sector multiple, as contained in Table 2.

6.1 P/E
The P/E ratio indicates the best valuation performance in the electronic and electrical
equipment, general financial, general retailers, industrial engineering, media, mining, real
estate, and technology and hardware sectors. In total, P/E ratios perform the best valuations

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Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

in 33% of the sectors, which is the best performance in aggregate, compared with the other
four multiples.
These results are supported by the PwC survey, which, although not sector specific,
indicated that the P/E ratio is the most popular multiple used in practice, scoring a 2 on
their frequency table. However, as the IPR results indicate, the P/E ratio does not perform
the most accurate equity valuations, that is, with the lowest dispersion of valuation errors,
across all sectors.
By plotting the preferred multiples currently applied in practice, in other words, the
practical multiple of choice (PMC) in these eight sectors on the MVC, an opportunity cost
for these multiples can be calculated. The opportunity cost of any multiple on the MVC
would be the foregone potential IMP as a result of not using the multiple in column IPR1 in
Table 2, that is, the research multiple of choice (RMC). Since the P/E ratio is the PMC and
the RMC for each of these eight sectors, the opportunity cost figure is zero in other
words, the multiple used in practice corresponds to the multiple suggested by the research
results.

6.2 MVIC/EBITDA
MVIC/EBITDA indicates the best valuation performance in the automobiles and parts,
chemicals, general industrials, software and computer services, support services and
industrial metals sectors. MVIC/EBITDA performs the best valuations in 25% of the
sectors, which indicates that it is probably one of the better options when choosing a
multiple for equity valuation purposes, especially if it is for equity valuations in the abovementioned six sectors.
These results concur with the frequency with which the MVIC/EBITDA is applied in
practice, since the PwC survey indicated that it is the second most popular multiple that is
applied in practice, scoring a 1.75 on their frequency table. As Table 3 indicates, the
potential IMP is 3% in the automobiles and parts sector, 32% in the chemicals sector, 41%
in the general industrials sector, 23% in the software and computer services sector, 32% in
the support services sector and a 20% in the industrial metals sector.
Table 3 contains the IPRs of the PMC and the RMC. The PwC survey indicated that the
PMC is the P/E ratio. The IPRs of the P/E ratio for each sector are therefore indicated in the
first column, labelled PMC. The IPR of the RMC for each sector was calculated and is
indicated in the column labelled RMC, that is, those multiples with the smallest dispersion
of valuation errors. The multiple description is included under the label Multiple. The
potential IMP between the PMC and the RMC in each sector illustrates the optimisation
gap, which indicates the 16 sectors in which the P/E ratio was outperformed by one of the
other four preferred multiples. As Table 3 indicates, there is a 22% average potential
performance improvement in the accuracy of valuations, ranging from 3% in the
automobiles and parts sector to 46% in the personal goods sector.

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Table 3

Optimisation gap: sectors in which the P/E ratio is outperformed by other


multiples

Sector
Automobiles & Parts
Banks
Chemicals
Construction & Materials
Equity Investment Instruments
Food & Drug Retailers
Food Producers
General Industrials
Industrial Metals
Industrial Transportation
Life Insurance
Nonlife Insurance
Personal Goods
Software & Computer Services
Support Services
Travel & Leisure
Average

PMC

Optimisation gap
RMC
Multiple

IMP

1.48
0.82
1.35
1.09
2.60
1.00
0.95
1.97
2.35
1.89
1.53
1.04
3.57
1.67
2.04
1.31
1.67

1.45
0.76
0.91
1.05
1.45
0.89
0.89
1.17
1.89
1.70
1.05
0.77
1.93
1.29
1.38
1.09
1.23

3%
8%
32%
4%
44%
12%
6%
41%
20%
10%
31%
26%
46%
23%
32%
16%
22%

MVIC/EBITDA
P/PBT
MVIC/EBITDA
MVIC/EBIT
P/BVE
MVIC/EBIT
MVIC/EBIT
MVIC/EBITDA
MVIC/EBITDA
MVIC/EBIT
P/BVE
P/BVE
P/BVE
MVIC/EBITDA
MVIC/EBITDA
MVIC/EBIT

PMC - practical multiple of choice; RMC - research multiple of choice; IMP - percentage potential improvement; P/E price earnings; MVIC - market value of invested capital; EBITDA - earnings before interest, tax, depreciation and
amortisation; EBIT - earnings before interest and tax; P/BVE - price/book value of equity; P/PBT - price/profit before tax

6.3 MVIC/EBIT
MVIC/EBIT indicated the best valuation performance in the construction and materials,
food producers, industrial transportation, travel and leisure, and food and drug retailers
sectors. MVIC/EBIT performs the best valuations in 21% of the sectors, which indicates
that, although it is not the most popular multiple across the board, it outperforms P/BVE
and P/PBT.
These results concur with the frequency with which MVIC/EBIT is applied in practice,
since the PwC survey indicates it as the third most popular multiple method, scoring
approximately 1.35 on their frequency table. The potential IMP in the accuracy of
valuations is 4% in the construction and materials sector, 6% in the food producers sector,
10% in the industrial transportation sector, 16% in the travel and leisure sector and 12% in
the food and drug retailers sector.

6.4 P/BVE
P/BVE indicated the best valuation performance in the equity investment instruments, life
insurance, nonlife insurance and personal goods sectors. P/BVE performs the best
valuations in 17% of the sectors, which indicates that it is not the best option when
choosing a multiple for equity valuation purposes, unless it is for equity valuations in the
above-mentioned four sectors.

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Multiples in the SA equity market: is the popularity of the P/E ratio justifiable from a sector perspective?

These results concur with the frequency with which P/BVE is applied in practice, since
the PwC survey indicates it as the fourth most popular multiple method, scoring 0.75 on
their frequency table. The potential IMP in the accuracy of valuations is 44% in the equity
investment instruments sector, 31% in the life insurance sector, 26% in the nonlife
insurance sector and 46% in the personal goods sector.

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6.5 P/PBT
P/PBT indicated the best valuation performance in the banking sector, that is, in 4% of the
sectors, which indicates that it is not the best option when choosing a multiple for equity
valuation purposes, unless it is for equity valuations in the banking sector.
These results concur with how frequently the P/PBT is applied in practice, since the PwC
survey indicated it as the least popular multiple of the top five multiples that are applied in
practice, scoring 0.5 on their frequency table. The potential IMP in the accuracy of
valuations is 8% in the banking sector.
The results therefore contrast the evidence from practice, which indicated that the P/E
ratio is the PMC, as suggested by the results of the PwC survey. The IPR calculations
contained in Table 2 indicate that the P/E ratio is the optimal multiple, that is, with a zero
optimisation gap, in only 33% of the sectors. The other four preferred multiples top the list
of best valuation performance for the remaining 67% of the sectors, which suggests that the
P/E ratio is not the best alternative across all sectors.

7 Conclusion
The primary focus of this article was to investigate whether the general preference for the
P/E ratio in practice matches the sector multiples that research seems to suggest. It was
shown that the P/E ratio, although widely advocated in academic circles and applied in
practice as the kingpin of multiples, is not the best multiple option across all sectors. The
research results supported the notion that different multiples should be used for different
sectors. This was evident from the optimisation gap, which approximated the potential
performance improvement that may be achieved in the accuracy of equity valuations.
After the data were extracted from the McGregor BFA database and screened, an
estimated sector multiple was calculated for each company by calculating the harmonic
mean of all the remaining companies in the industry concerned. The estimated multiples
were multiplied by the companys specific value driver to arrive at a value indicator for the
companys shares. The difference between these value indicators and the actual share
values was subsequently calculated to create a pool of valuation errors. The dispersion of
the pool of valuation errors for each multiple was measured for each sector by calculating
the IPR. The IPRs of each of the five most popular multiples in practice (per sector) were
compared, in an attempt to establish which multiples may be more suited to a specific
sector. To this end, an MVC was created, ranking the multiples from the widest to the
narrowest dispersion of valuation errors per sector, indicating the potential valuation
performance enhancement that could be achieved by choosing a multiple that performs a
more accurate equity valuation.
The results should be considered with caution. The research depended on the availability
of data, and clinical calculations such as the harmonic mean were used. Although the
clinical selection of comparable companies may erode the performance of multiples,
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especially when using a large data pool, this should not detract from the relative
performance amongst multiples since all multiples were selected in a similar fashion.
Clearly, analysts may follow a more careful selection process and take into account specific
factors that were not considered in this research exercise.
The research indicates the following: Firstly, as was evident from the results of the PwC
survey, the P/E ratio is the preferred multiple that is used in practice. However, the results
of the research revealed that the P/E ratio performs the most accurate equity valuation in
only 33% of the sectors, indicating that it is not the most optimal multiple in all the sectors.
The reader should again consider these results with caution since a reduction in the IPR
from 5% to 95%, which was used for the research analysis, to the interquartile range, for
example, causes the P/E ratios position as the optimal multiple to decline to only 25% of
the sectors. However, for all the different measures of dispersion that were tested, the
results indicated that a carte blanche application of the P/E ratio across all sectors is ill
advised.
Secondly, the results of the IPR calculations indicate that each of the five most popular
multiples, as per the PwC survey, outperforms the other four in certain sectors. It is
therefore evident that different multiples should be used for different sectors, as indicated
by the optimisation gap, which was calculated for each of the 16 sectors in which a multiple
other than the P/E ratio was found to perform the most accurate equity valuations. To this
end, the valuation performance of the P/E ratio was pitted against that of the best
performing sector multiple in these 16 sectors. The results indicate that by substituting the
P/E ratio for one of the other four preferred multiples in these sectors, the accuracy of the
valuations can be improved by between 3 and 46%.
What are the implications? Finance lecturers in academia generally proclaim that the P/E
ratio is the most widely used multiple in practice and rightly so. However, the P/E ratio is
not the most accurate multiple per se, since it does not necessarily constitute best practice
across all sectors. The academic environment would do well to take cognisance of these
results and present the P/E ratio with the necessary caution to their students. Although, in
practice, analysts do not view multiples in isolation, but rather consider a range of
multiples, and usually in conjunction with more comprehensive models, the evidence does
suggest that there is a somewhat large, probably unwarranted, emphasis on the P/E ratio.

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