382  Using Multiples must include it in the enterprise value calculation. Otherwise, the EV-to-EBITA multiple will be biased downward. For instance, when only debt plus equity is divided by EBITA for Company C, the resulting multiple is only 8 times. As a general rule, any nonoperating asset that does not contribute to EBITA should be removed from enterprise value. This includes not only the market value of excess cash and nonconsolidated subsidiaries, as just mentioned, but also excess real estate, other investments, and the market value of prepaid pension assets. Financial claims include debt and equity, but also minority interest, the value of unfunded pension liabilities, and the value of employee grants outstanding. A detailed discussion of nonoperating assets and financial claims is presented in Chapter 16. A trickier adjustment is needed for pensions and other retirement benefits, as explained in Chapter 23. Treat the unfunded liabilities as debt or the excess assets as a nonoperating asset. In addition, exclude the nonoperating parts of pension expense from EBITA. Use the Right Peer Group Selecting the right peer group is critical to coming up with a reasonable valua- tion using multiples. Common practice is to select a group of 8 to 15 peers and take the average of the multiples of the peers. Getting a reasonable valuation, though, requires judgment about which companies and their multiples are truly relevant for the valuation. A common approach to identifying peers is to use the Standard Industrial Classification (SIC) codes or the newer Global Industry Classification Stan- dard (GICS) system developed by Standard & Poor’s and Morgan Stanley.9 These may be a good starting point, but they are usually too broad for a good valuation analysis. For example, United Parcel Service (UPS) is included in the air freight and logistics GICS code, which includes dozens of companies, most of which do not compete with UPS in its core business of delivering small par- cels. Another approach is to use peers provided by the company being valued. However, companies often provide aspirational peers rather than companies that truly compete head-to-head. It is better to have a smaller number of peers of companies that truly compete in the same markets with similar products and services. Even if you find companies that compete head-to-head, differences in per- formance may justify differences in multiples. Remember the value driver for- mula expressed as a multiple: 9 Beginning in 1997, SIC codes were replaced by a major revision called the North American Industry Classification System (NAICS). The NAICS six-digit code not only provides for newer industries but also reorganizes the categories on a production/process-oriented basis. The Securities and Exchange Commission (SEC), however, still lists companies by SIC code. Use the Right Peer Group  383 Value EBITA = (1 ) 1 g ROIC WACC g − −     − T or Value NOPAT ROIC WACC = −     − 1 g g As both versions of the formula indicate, a company’s EBITA or NOPAT valu- ation multiple is driven by growth (g), ROIC, and the weighted average cost of capital (WACC). While most peers will have similar costs of capital, the other variables may be different, leading to differences in expected multiples. A common flaw is to compare a particular company’s multiple with an average multiple of other companies in the same industry, regardless of dif- ferences in their performance. Better to use a smaller subsample of peers with similar performance. Exhibit 18.11 shows the multiples of nine disguised com- panies that manufacture equipment and provide services for oil and gas drill- ing. The EV-to-NOPAT multiples range from approximately 10 times to almost 17 times. The company being evaluated, Swallow, had a multiple of 12 times, at the lower end of the range. Does this mean the company is undervalued? Probably not. When you examine the performance of the companies, you can see that they neatly divide into three groups: a top group with multiples of about 15 to 17 times, a middle group with multiples of about 12 times, and a low group with multiples of about 10 times. Note that the ROIC and growth Exhibit 18.11  Peer Groups by ROIC and Growth Deer Buffalo Pig Swallow Robin Owl Shark Porpoise Whale Peer group A Peer group B Peer group C 10.2 12.3 12.4 12.4 14.8 16.3 16.8 EV/NOPAT, 2014E ROIC, 2014E Forecast revenue growth,1 2013–2015 % 10.1 10.1 6 9 8 10 19 22 29 5 5 6 8 10 9 10 13 11 6 7 1 Compound annual growth rate.