368  Using Multiples trading right in line with its peers. The reason for the difference was that their company had much more debt relative to equity than the other companies. We estimated that if the company had had the same relative debt as its peers, its P/E also would have been 14. Except for very-high-growth companies, a company with higher debt relative to peers will have a lower P/E because more debt translates to higher risk for shareholders and a higher cost of eq- uity. Therefore, each dollar of earnings (and cash flow to shareholders) will be worth less to an investor.1 To use earnings multiples properly, you should dig into the accounting statements to make sure you are comparing companies on an apples-to-apples basis. You also must choose the right companies to compare. Keep in mind these five principles for correctly using earnings multiples: 1. Value multibusiness companies as a sum of their parts. Even companies that appear to be in a single industry will often compete in subindustries or product areas with widely varying return on invested capital (ROIC) and growth, leading to substantial variations in multiples. 2. Use forward estimates of earnings. Multiples using forward earnings es- timates typically have much lower variation across peers, leading to a narrower range of uncertainty of value. They also embed future expec- tations better than multiples based on historical data. 3. Use the right multiple, usually net enterprise value to EBITA or net enterprise value to NOPAT. Although the P/E is widely used, it is distorted by capi- tal structure and nonoperating gains and losses. (In this book, when we 1 The P/E multiple is a function of return on capital, cost of capital, and growth. For very-high-growth companies, whose enterprise multiples are greater than the multiple for debt, the multiple will actually increase with leverage. See also Appendix D. Exhibit 18.1  Multiples for Packaged Foods Companies $ billion Multiples Company Market value of equity Enterprise value (equity + debt) Net income (1 year forward) EBITA (1 year forward) Price/ earnings Enterprise value/EBITA A 2,783 9,940 381 929 7.3 10.7 B 13,186 16,279 856 1,428 15.4 11.4 C 8,973 11,217 665 1,089 13.5 10.3 D 14,851 22,501 1,053 2,009 14.1 11.2 Mean 12.6 10.9 Median 13.8 11.0 Mean (excluding A) 14.3 11.0 Median (excluding A) 14.1 11.2 Value Multibusiness Companies as a Sum of Their Parts  369 refer to the enterprise value multiple, including abbreviations such as EV/EBITA, we use “enterprise value” as shorthand for net enterprise value, equal to the value of operations.) 4. Adjust the multiple for nonoperating items. Nonoperating items embedded in reported EBITA, as well as balance sheet items like excess cash and pension items, can lead to large distortions of multiples. 5. Use the right peer group, not a broad industry average. A good peer group consists of companies that not only operate in the same industry but also have similar prospects for ROIC and growth. Value Multibusiness Companies as a Sum of Their Parts Most large companies, even if they operate in a single industry, have business units that are in subindustries with different competitive dynamics and there- fore differ widely in ROIC and growth. For example, many analysts would classify Johnson & Johnson as a health-care company, but its three major units (pharmaceuticals, medical devices, and consumer health products) have widely varying economic characteristics in terms of growth and return on capital. Each of the units will therefore have different valuation multiples. For such multibusiness companies, a valuation using multiples requires a sum-of- parts approach, which values each business unit with a multiple appropriate to its peers and performance. Even companies in more narrowly defined sectors often have units with different economics. For example, oil and gas services companies provide oil and gas companies with equipment and services that might include bottom hole assemblies, drill pipes, pressure-control services, intervention services, pressure pumping, fluid handling, subsea construction, and even temporary housing for workers. Some of these product areas, including bottom hole as- semblies and drill pipes, tend to earn much higher returns on capital than pressure-control services and intervention services. Ideally, you would value units by using as fine-grained an approach as possible, comparing them with companies that have similar units and economics. For an example of a good sum-of-parts valuation, see Exhibit 18.2. For each unit of this disguised company, we apply a different multiple to its earnings based on different peers. Then we sum the values of the units to estimate net enterprise value. To estimate equity value, we add nonoperating assets and subtract debt and debt equivalents. Note that the business unit multiples range from the midteens to below ten. Without the sum-of-parts approach, it would be impossible to value this company accurately. We also used ranges for the value of each unit, reflecting the imprecision of valuing any business based on the valuation of peers at a single point in time.