386  Using Multiples growth over the first ten years (10 percent, versus 5 percent for A). The DCF valuations of both companies at a 9 percent cost of capital and no debt lead to the same earnings multiple: 17 times. But Company A’s PEG ratio is 3.4, while Company B’s is 1.7. The common interpretation is that Company A is overvalued relative to Company B because its PEG ratio is higher. Yet it’s clear that both companies are valued the same when both growth and ROIC are taken into account. Multiples of Invested Capital In some industries, multiples based on invested capital can provide better insights than earnings multiples. One example comes from the banking in- dustry. In the years after the 2008 credit crisis, there was tremendous uncer- tainty about what levels of return on equity banks would be able to earn.10 Furthermore, earnings forecasts one to three years out were not reliable and were often negative. Most investors resorted to using multiples of book equity. Banks with higher expected long-term returns on equity, based on their mix of businesses and the underlying economics of those businesses, tended to have higher multiples than banks in lower-return businesses. For example, banks whose portfolios emphasized wealth management and transaction process- ing, which are stable and earn high returns, were valued at higher multiples to equity than banks focused on more volatile and lower-return investment banking and retail banking. Regulated industries provide another application of invested capital mul- tiples. Under some regulatory regimes, profits are capped by the allowed return on a company’s so-called regulatory asset base (RAB). The RAB is separately reported and represents the invested capital as calculated follow- ing certain rules that the regulator sets for qualified capital expenditures. If regulators were to not allow any excess returns above the cost of capital, the enterprise value-to-RAB multiple of a regulated company should be (close to) 1. In practice, the multiples end up at higher levels because regulators often provide various efficiency incentives allowing companies to generate excess returns. In addition, most companies have growth opportunities; they can ex- pand their RAB by new, approved investment projects. For companies under similar regulatory regimes, many investors and analysts use RAB multiples for comparison and valuation. Multiples Based on Operating Metrics Sometimes company valuations are based on multiples of operating metrics. For example, values of oil and gas companies can be expressed as value per 10 As explained in Chapter 38, we use return on equity, rather than return on capital, for banks. Alternative Multiples  387 barrel of oil reserves. Clearly, the amount of oil reserves in the ground the company has access to will drive the company’s value. While the value of each barrel once the oil is extracted and sold is roughly the same, the costs to extract those barrels will vary widely and affect profit per barrel, depending on the geology of those reserves and the techniques needed to extract them. When estimating the value of an oil and gas company based on a valuation multiple of the amount of reserves it holds, you therefore have to make adjustments for any differences in the costs of extraction and distribution relative to the companies for which the multiple was estimated. In other cases, investors and analysts resort to operating multiples when valuing young, fast-growing companies, because of the great uncertainty sur- rounding potential market size, profitability, and required investments. Fi- nancial multiples that normally provide a benchmark for valuation are often useless, as profitability (measured in any form) is often negative. A way to overcome this shortcoming is to apply nonfinancial multiples, comparing en- terprise value with operating statistics such as website hits, unique visitors, or number of users or subscribers. This happened, for example, in the late 1990s, when numerous Internet companies went public with meager sales and nega- tive profits. In 2000, Fortune reported market-value-to-customer multiples for a series of Internet companies.11 Fortune determined that Yahoo was trading at $2,038 per customer, Amazon.com at $1,400 per customer, and NetZero at $1,140 per customer. Today, similar multiples are sometimes used to analyze and compare the valuation of fast-growing companies with digital user–based or subscrip- tion-based business models. For example, the market value of audio- and video-streaming companies Netflix, Spotify, and Sirius XM can be expressed per paying user or subscriber. As of July 2019, Netflix was trading at about $1,200 per subscriber, Spotify at about $200 per subscriber, and Sirius XM at $900 per subscriber.12 The question is whether such multiples offer real insights. Effective use of a nonfinancial multiple requires that the nonfinancial met- ric be a reasonable predictor of future value creation and thus somehow tied to ROIC and growth. Simply taking the average of the customer or subscriber multiples for a set of apparently similar businesses provides little, if any, in- sight. Netflix, Spotify, and Sirius XM differ in terms of the underlying drivers of revenues and costs per user, because they operate with distinct business models. Netflix streams TV series, films, and documentaries on demand, and 11 E. Schonfeld, “How Much Are Your Eyeballs Worth?” Fortune, February 21, 2000, 197–200. 12 As of mid-2019, Netflix had an enterprise value of about $180 billion and about 150 million paying users, Spotify had a value of about $23 billion and 110 million paying users, and Sirius XM had a value of about $32 billion and 35 million paying users.