International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

DOI: http://dx.doi.org/10.7708/ijtte.2015.5(1).03 UDC: 005.334:656.7

MARKET MULTIPLES ADJUSTMENTS FOR DIFFERENCES IN RISK

PROFILE – AN AIRLINE COMPANY EXAMPLE
Nina Milenković1
1
KPMG LLC Belgrade, Kraljice Natalije 11, 11000 Belgrade, Serbia
Received 26 November 2014; accepted 19 January 2015

Abstract: Companies whose data can be found in databases usually are not comparable enough
to the valuation subject to assure direct use of their multiples (i.e. to assure reliability of valuation
resulting from direct use of their multiples). Key differences usually relate to size, but also to other
characteristics (financial performance, territory, business profile, expected growth, etc.), all of
impact on specific risks. This paper shows how to adjust multiples for risk profile differences to
achieve satisfactory level of comparability and consequent reliability of valuation on the example
of airline company.

Keywords: valuation, market multiples, capitalization rate, WACC, specific risks.

1. Introduction comprehensive information about a large

number of companies, but only for those
The market approach is one of the traditional companies that exceed threshold values
approaches to valuation. It is based on the in terms of size (thresholds vary, but they
principle of substitution and the premise that mainly relate to annual turnover in excess
a rational investor will not pay for an asset/ of 50 million USD).
company a higher amount than he would
pay on the market for the purchase of an W hen the valuation subject is a large
asset/company with similar characteristics company, a multinational or one that
and utility. As a result, application of the operates on a developed market, most often
market approach usually includes the use of the multiples can be used directly. However,
market multiples calculated for comparable when undeveloped or emerging markets are
companies that are listed on active stock involved, in which the business environment
markets or that have recently been sold/ differs significantly, and valuation subject
purchased. Multiples are based on data companies are often as much as one hundred
about market value of equity and debt, and times smaller, direct use of multiples would
information from financial statements of produce distorted results, mostly with
selected comparable companies. The sources significant overestimation of their value.
of data about comparable companies are For this reason market multiples need to
usually specialized databases (Bloomberg, be adjusted by a factor or factors which will
Capit a l IQ , A madeu s, I n f i na nc ia l s, take into account key differences between a
Damodaran, etc.). These databases contain selected sample and the valuation subject.

1
Corresponding author: [email protected]

17
 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

These factors are very often determined valuation subject operates represents a
subjectively, based on qualitative analysis of simple modification of country risk which
risk profile and the appraiser’s experience. is used in determining the discount rate and
However, it is precisely the subjectivity of is calculated as follows:
such an approach that represents its greatest
weakness, because the result is directly (1)
dependent on the level of adjustment, and
is perforce subject to error and even to
manipulation. That is why it is much better where:
if the adjustment factor is determined Madj – adjusted multiple,
using a quantitative method. It is desirable, Mor – original multiple,
therefore, for factors that are taken into YTM B – yield to maturity of government
account for the adjustment to be consistent bonds of the benchmark country,
with factors that were used in determining YTMC – yield to maturity of government
the discount rate as part of the income bonds of the country of the valuation subject.
approach.
The prerequisite for use of this method
The paper considers the most common is for comparable bonds to have identical
quantitative methods and techniques for maturities (measured in days). If this is
adjusting multiples. Special attention is not the case, the yield to maturity needs to
given to methods that include individual be recalculated in order for currency and
or combined consideration of risk factors maturity to be the same (Ivashkovskaya and
which is consistently or directly linked to Kuznetsov (2007) recalculate maturities
the discount rate. using regression).

2. Adjustments for Market Differences Moreover, at tent ion shou ld be g iven

to the currency in which the bonds are
The commonest reason that appraisers denominated: it is not necessary for the
mention for correcting multiples are market currencies to be the same, but this should
differences, namely the fact that doing be kept in mind in interpreting the results
business in an emerging market generally (whether the adjustment also contains
differs significantly from doing business currency risk or not).
in developed markets. Isolated adjusting of
multiples for differences in market risks can The advantage of this method is that it is
be carried out in several ways: fairly straightforward and can be applied
using any type of multiple, irrespective
• through yields on government bonds, of whether it is based on earnings level or
• t h roug h rel at ive rat ios bet ween assets (see Appendix 1 for more on types and
multiples, definitions of multiples). The main drawback
• regression analysis. is that it completely ignores other specific
risks of companies in emerging markets.
Adjustment through yields on government
bonds of countries in which comparable Relative ratios bet ween multiples a re
companies are located and in which the conceptually based on a comparison of

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International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

average multiples for the entire economy 3. Adjustments for Differences in other
of two countries in a specific time period. Risk Factors
After this, such a general ratio is applied to
specific multiples calculated from the sample A s already mentioned, dif ferences in
of comparable companies. market conditions of doing business are
often not the only significant differences
(2) between companies whose data is available
in databases and publications and the
where all symbols carry the same meaning valuation subject company. That is why an
as in Eq. (1). unavoidable step in using market multiples
includes a detailed analysis of individual
This method is slightly better than the risk factors of companies in the sample and
previous one, because the average multiple the valuation subject company, based on
for the entire country also includes other which it is concluded whether a certain factor
risks, beside the basic country risk. It can also has a dominant role or whether differences
be applied to all types of multiples. However, are evenly distributed (sometimes they
in order for it to be applicable, it is necessary also relate to factors that cannot be directly
for the country where the valuation subject is quantified). Depending on the results of
located to have an active securities market, the analysis, adjustment methods are used
for accounting standards to be comparable for individual factors or for the risk profile
and for a sufficiently large number of as a whole.
companies to be included in order for the
multiple to be considered representative. It 3.1. Adjustments for Individual Risk
is precisely for this reason that this method Factors
would not provide sufficiently reliable results
for companies in Serbia. The most frequently identified individual
risk factors that are dominantly incomparable
Adjustments using regression analysis are are expected profit growth and company size.
based on the idea that the value of a multiple Namely, it is common for larger companies
depends on the fundamental variable on and companies with faster expected growth
which it is based and on the dummy variable to have higher multiples than those that are
which represents the country/market where smaller and that have lower expectations in
business is conducted. Prerequisites for the the future.
use of this method are similar as with the
relative ratio of multiples. Depending on Based on the relationship between the most
data availability, this method frequently general multiple P/E, risk rate and long-
provides excellent results. Also, it can be term growth rate (for further details see
expended by adding variables (actual or Appendix 2) and the fact that both factors are
dummy) that relate to other risk factors additive in the denominator of the ratio (10),
such as commercial activity, size, growth, a formula has been derived for adjustment of
etc. (for more details see Ivashkovskaya and multiples for individual risk factors which is
Kuznetsov, 2007; Welc, 2011; Acosta, 2011). as follows for a general case:

19
 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

the appropriate discount rate. By calculating

(3) the ratio between this value and initial profit
levels one gets the indirectly assumed rate of
capitalization, from which (using the same
where symbols carry the same meaning as discount rate) one gets the blended growth
in Eq. (1). rate (more detailed explanation provided
by Hitchner (2003), with one calculation
The adjustment factor in this method is method provided by Tallis (2012)).
usually the difference in the selected risk
factor measure between the benchmark and In order for the adjustment result to be
the valuation subject company (when factor valid, care must be taken of the consistency
is of the same direction as the multiple value). between the denominator of the multiple
and the growth rate, as well as between the
The formula for adjusting the multiple for numerator and the discount rate. Moreover,
the difference in expected profit growth is such adjustment only makes sense for
as follows: earnings based multiples, and not for asset
based multiples.
(4)
For adjusting the multiple for the difference
in company size, the formula is as follows:
where g stands for the blended long-term
growth rate, the index s for the specific (5)
valuation subject company, while other
symbols and indices remain as before.
where SRP stands for specific risk premium
In order for this method to be applied, it for company size, while other symbols and
is necessary to calculate the blended long- indices remain as before.
term growth rate. Namely, the growth rate
which is implicitly contained in the discount The effect of the risk premium on the multiple
rate represents a steady growth rate for an has an opposite direction with respect to
indefinite period into the future, which for company size, such that the benchmark
the majority of commercial activities and and the valuation subject company have
companies over a sufficiently long period changed places in the adjustment multiple.
converges with the long-term GDP growth It is assumed that the benchmark companies
rate. Differences in growth, hence, relate are larger than the subject company, i.e. that
to a period of the next 3-5 years, which is the subject company has higher size risk
most frequently the subject of estimates and premium.
projections made by company management
and financial analysts. The blended rate The risk premium for company size is
is calculated by firstly calculating the taken by the majority of appraisers from
projection of profit levels, based on the initial statistics publications published by Ibbotson
value of profit and projected growth rates for Associates. Unfortunately, this data relates
different periods, after which the present to American or global companies which,
value of future profits is calculated using even being in the tenth decile (the smallest

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International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

one), are frequently dramatically larger is intended (revenue, EBITDA, EBIT),

than Serbian companies; in other words, modifying coefficient α, representing the
risk premiums for size within the tenth ratio between net income and the other
decile are not sufficiently differentiated. earnings measure, must be applied.
A possible solution has been announced in
Dragon (2010): Chinese statistics for small Finally, it should be noted that country risk
companies whose shares are regularly traded can also be used as an adjustment factor.
on securities markets. Another disadvantage
of isolated size-based adjustment is presented A l l of t he above adjust ments ca n be
in Grabowski (2014), based on Peek (2014). combined, but generating a single formula
Study shows that the relationship between would be unnecessarily complicated – it is
firm size and returns could not be seen as simpler to carry out several successive steps
linear and straightforward, because it varies (Mercer, 2013). The risk of such procedure
across regions. is a drastic decrease in the multiple.

The adjustments described in Eqs. (4) and 3.2. Adjustments for Combined Risk
(5) relate to the P/E multiple. In order for it Factors through the Discount Rate
to be applicable to other multiples, additional
adjustments need to be made, which for a W hen a na lysis does not point to t he
general case can be presented as: dominant effect of any particular risk factor
or there are several significant factors, so
(6) successive adjustments would reduce the
multiple to an illogically small value or, on
the other hand, there are significant specific
where: risks that are not typical for companies in
α –modifying coefficient for variations in developed markets, it is the best solution
the multiple denominator, to combine all factors through the discount
ε – modifying coefficient for variations in rate, as follows:
the multiple numerator.
(7)
The equivalent for the P/E multiple applicable
for i nvested capita l is M V IC/EBI AT
(Earnings Before Interest After Taxes). Given where DR stands for the discount rate, while
that the size risk premium is part of the cost of other symbols and indices remain as before.
equity, it will affect WACC only to the extent
that equity participates in the invested capital The “adjusting” discount rate for comparable
(see Appendix 3). Hence, in order for Eq. (5) companies is calculated in usual way (see
to be applicable to the MVIC multiple, the Appendix 3). In doing so, the risk free rate,
adjustment factor must be multiplied by the country risk and risk premium for size are
modifying coefficient ε, which represents the taken from actual data for the country and
share of equity in invested capital. the company, while for other components
average values (best to use median values) of
Furthermore, if the use of a multiple which the entire sample of comparable companies
is based on another earnings measure are taken.

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 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

Since the ratio of rates is a relative (unnamed) creditors and lessors, as loans are expensive
number, this method can be applied to and often secured by very mobile and saleable
any multiple, with one (methodo)logical asset, i.e. aircraft. On the other hand, reward
limitation: the multiple numerator and for equity owners is permanently below the
discount rates used must be consistent. In opportunity cost, measured by WACC.
other words, there is no sense in adjusting According to IATA (2014), although trends
equity multiples by ratio of two WACCs. are improving during the last two years and
expected ROIC (return on invested capital)
A lternatively, the discount rates of the for 2014 is 5.4%, it is “more than 2 percentage
valuation subject company and comparable points lower than it should be in an industry
companies can be used in Eq. (5) instead of that is highly competitive” (IATA, 2014).
SRP, where as in the previous method, care
should be taken of the consistency between However, not all companies fit in this profile.
the multiple and the discount rate. Of course, Some of them are in deleveraging process,
introduction of coefficient α is mandatory, while others restructure its debt increasing
representing the ratio between net profit use of leasing (both operating and financial);
and cash flow. Besides conjoint capturing they operate in different countries, with
of more risks, the advantage of this method different degree of government regulations;
lies in its simplicity (data has already been different business models are in place as
collected for determining the discount rate well as different stages in lifecycle. A lot
for the income approach), as well as in its of those differences are not clearly visible
direct link to the income approach. Thus it or assessable from information available in
is highly unlikely for results to differ to such databases. Multiple adjustments procedure
an extent that the market approach cannot be is illustrated on the example of regional
applied. Should this nevertheless happens, airline company; as it is real company, for
it is necessary to reconsider the selection of confidentiality reasons here it is named
companies, assumptions and calculations in Eastern Air. Basic company financials are
the income approach, and in the event of a shown in Table 1.
significant difference in expected growth, it
is sometimes necessary to apply an additional Table 1
adjustment for this factor. Basic Financials for Eastern Air for the Last Fiscal Year
Eastern Air 000 USD
4. An Illustrative Example: Airline
Book Value of Equity 74.90
Company Total Debt (Leasing) 2,801.90
Invested Capital(D+E) 2,876.80
A good example of combined risk factors are Cash 1.00
companies from airline industry. In brief, Enterprise Value 2,875.80
industry economic profile is characterized Debt to Invested Capital ratio (D/D+E) 97.40%
by low profits, high indebtedness and uneven Debt to Equity ratio (D/E) 3740.86%
distribution of returns and risk across the Revenues 6,489.90
value chain (a thorough analysis of air EBITDA 659.60
transport value chain is presented in Pearce EBIT 50.02
(2013)). Regarding investment attractiveness, Net Income (16.22)
air industry rewards debt providers, both Source: Financial statements for the last fiscal year

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International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

The company operates mostly in Europe, Having relatively new fleet, well operating
having a few intercontinental lines as well. regional lines and access to some interesting
The majority owner is state, and minority airports, the company could be a desirable
shareholders are also mostly government acquisition target. For the purpose of
institutions. Shares are not quoted on the illustration it is assumed that potential
local stock exchange. acquirer’s consultant is asked to conduct
a qu ick i nd icat ive va luat ion. Ma rket
The company is highly indebted and whole multiples are often the first choice. The
debt is in form of leasing. Bad management consultant formed peer group, using data
combined with high interest expenses lead from Damodaran database (available from
company to loss making zone, so the book Internet: <www.damodaran.com>, free of
value of equity is very low. charge). Multiples are shown in Table 2.
Table 2
Market Multiples
        Market Multiples - Unadjusted
Market Market EV/ EV/ EV/
Company Name Country PE PS
cap D/D+E EBIT EBITDA Sales
Finnair Oyj Finland 489.2 73.44% 16.31 0.15 11.23 8.95 0.51
Air France-KLM SA France 3,092.6 87.67% NA 0.09 35.01 12.56 0.59
Aegean Airlines S.A. Greece 575.3 36.65% 7.41 0.66 3.99 270.17 0.68
Icelandair Group hf. Iceland 788.2 29.55% 13.76 0.88 8.17 8.46 1.01
Aer Lingus Group plc Ireland 939.3 49.42% 22.31 0.51 16.51 8.10 0.78
Norwegian Air Shuttle ASA Norway 1,090.1 74.05% 12.17 0.47 NA 20.17 1.66
Aeroflot - Russian Airlines Russia 2,688.5 67.13% 6.25 0.33 9.04 11.37 0.91
Transaero Airlines Russia 725.8 77.41% 21.86 0.23 13.90 12.23 0.99
UTair Aviation Russia 393.3 83.85% 28.50 0.15 5.41 8.27 0.92
SAS AB Sweden 845.5 67.79% 30.75 0.13 3.51 3.64 0.29
Türk Hava Yollari A.O. Turkey 4,140.1 59.08% 7.72 0.50 9.50 7.44 1.11
Pegasus Hava Tasimaciligi
Turkey 1,729.5 29.97% 17.49 1.61 8.93 12.03 1.85
Anonim Sirket
Median     67.46% 16.31 0.40 9.04 10.16 0.92

Comparing Eastern Air’s profile with peer are data in database about debt structure and
group, it is obvious that all selected companies amount of leasing, there are no information
are much bigger, are settled in more developed on type and terms of leasing. A ll those
countries and are less indebted. Moreover, differences and potential differences make
there is no information about assets/f leet multiple adjustments necessary.
values, but comparing EBITDA and EBIT
multiples it seems that i) depreciation share in In calculation of “adjusting” WACC for
revenue is lower in comparable companies and comparable companies and Eastern Air
ii) some of the companies have non-cash non- the build-up method is selected and the
operating revenues. Finally, although there following components are used (Table 3):

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 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

• risk-free rate: return on US government • cost of debt (after-tax): median of

bonds as at valuation date, comparable companies’ data,
• market r isk premium: consu ltant • capital structure: median of comparable
estimation, based on different research companies’ data.
studies,
• country risk premium: assessed for each It is important to mention that calculated
country, based on credit rating, “adjusting” WACC is not the actual WACC
• size risk premium: from Ibbotson for those companies and that specific
Associates Yearbook, in line with market company risk could also be added.
capitalization,

Table 3
“Adjusting” WACC Calculation
Risk- Cost of Cost of Adj.
Company Name ERP CRP SRP E/D+E
free Equity Debt WACC

Finnair Oyj 4.00% 5.50% 0.0% 2.65% 12.15% 4.75% 32.54% 7.16%

Air France-KLM SA 4.00% 5.50% 0.6% 1.20% 11.30% 4.75% 32.54% 6.88%

Aegean Airlines S.A. 4.00% 5.50% 8.5% 2.65% 20.65% 4.75% 32.54% 9.92%

Icelandair Group hf. 4.00% 5.50% 2.4% 1.88% 13.78% 4.75% 32.54% 7.69%

Aer Lingus Group plc 4.00% 5.50% 2.4% 1.88% 13.78% 4.75% 32.54% 7.69%

Norwegian Air Shuttle ASA 4.00% 5.50% 0.0% 1.88% 11.38% 4.75% 32.54% 6.91%

Aeroflot - Russian Airlines 4.00% 5.50% 1.6% 1.20% 12.30% 4.75% 32.54% 7.21%

Transaero Airlines 4.00% 5.50% 1.6% 2.65% 13.75% 4.75% 32.54% 7.68%

UTair Aviation 4.00% 5.50% 1.6% 2.94% 14.04% 4.75% 32.54% 7.77%

SAS AB 4.00% 5.50% 0.0% 1.88% 11.38% 4.75% 32.54% 6.91%

Türk Hava Yollari A.O. 4.00% 5.50% 2.5% 1.01% 13.01% 4.75% 32.54% 7.44%
Pegasus Hava Tasimaciligi
4.00% 5.50% 2.5% 1.82% 13.82% 4.75% 32.54% 7.70%
Anonim Sirket
Eastern Air 4.00% 5.50% 4.00% 12.06% 25.56% 4.75% 32.54% 11.52%

In final step, consultant calculated two multiples (Table 4). Then median value
adjusting factors, one for equity multiples of each multiple is selected and applied to
(ratio between two costs of equity) and for appropriate earnings level of Eastern Air.
enterprise value multiples (ratio between For the simplicity purpose, discount and
two WACCs) and applied them to market premiums were not applied.

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International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

Table 4
Adjusted Multiples and Valuation Analysis
      Market Multiples - Adjusted
Adj.factor Adj.factor
EV/ EV/ EV/
Company Name for equity for EV PE PS
EBIT EBITDA Sales
multiples multiples
Finnair Oyj 0.48 0.62 7.75 0.07 6.98 5.56 0.32
Air France-KLM SA 0.44 0.60 NA 0.04 20.91 7.50 0.35
Aegean Airlines S.A. 0.81 0.86 5.99 0.53 3.44 232.71 0.59
Icelandair Group hf. 0.54 0.67 7.42 0.47 5.45 5.65 0.67
Aer Lingus Group plc 0.54 0.67 12.03 0.27 11.02 5.41 0.52
Norwegian Air Shuttle
0.45 0.60 5.42 0.21 NA 12.09 1.00
ASA
Aeroflot - Russian
0.48 0.63 3.01 0.16 5.65 7.11 0.57
Airlines
Transaero Airlines 0.54 0.67 11.76 0.12 9.26 8.15 0.66
UTair Aviation 0.55 0.67 15.65 0.08 3.65 5.58 0.62
SAS AB 0.45 0.60 13.69 0.06 2.10 2.18 0.17
Türk Hava Yollari A.O. 0.51 0.65 3.93 0.25 6.13 4.80 0.72
Pegasus Hava
Tasimaciligi Anonim 0.54 0.67 9.46 0.87 5.97 8.04 1.24
Sirket
Median     7.75 0.18 5.97 6.38 0.60
Multiple base     Earnings Sales EBIT EBITDA Sales
Eastern Air actuals (16.2) 6,489.9 50.0 659.6 6,489.9
Enterprise value         298.6 4,207.4 3,914.6
Interest bearing debt (2,801.9) (2,801.9) (2,801.9)
Cash         1.0 1.0 1.0
Preliminary value (125.8) 1,194.3 (2,502.3) 1,406.5 1,113.7
Appraised value
of equity, non-
    0 1,200.0 0 1,400.0 1,100.0
controlling,
marketable (rounded)

As earnings and EBIT multiple give negative world valuation, the result would be either
values, resulting value of equity would be value range from 1.1 to 1.4 mil.USD or single
zero, but due to negative earnings and very point value - the most probably, value based
low EBIT, those two multiples should have on EBITDA multiple, i.e. 1.4 mil.USD (final
been excluded from the analysis at the value reconciliation and discussion is beyond
beginning (left here for illustration). In real the scope of this paper).

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 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

5. Conclusion In multiple selection and calculation the logic

and consistency are of critical importance, so
Insufficient comparability between small only mutually consistent items should form
compa n ies i n emerg i ng ma rkets a nd ratios (for example, it does not make sense
companies for which data can be found to form ratio “invested capital to earnings”
in specialized databases and publications due to inconsistency in debt treatment).
frequently leads to unreliable valuation
results generated using the market approach, The most common equity multiples are:
so its application is often being limited to
only illustrative/control purposes. • P/E (Price to Earnings) – Market
capitalization to net income,
This paper presents the main sources of • P/S (P r i c e t o S a l e s) - M a r k e t
differences and the most frequently used capitalization to net sales or operating
methods for adjusting market multiples. revenue,
A detailed analysis of risk profile is very • P/BV (Price to Book Value) - Market
useful in the selection of the method and capitalization to book value of equity.
risk factors for adjustment, but the ultimate
choice always rests with the appraiser. The most common invested capital multiples
(invested capital equals equity plus interest
The author of this paper holds that even bearing debt; often is called firm value; when
in the event when a single risk factor is cash is subtracted, it is enterprise value):
a dominant source of risk, adjustments
through the discount rate are the best choice • MVIC/EBIT (Market Value of Invested
as they take into account those risks which Capital to EBIT) – Market value of
are not directly quantifiable (key person, invested capital (market capitalization
lack of corporate governance, organizational plus market value of interest bearing
structure, etc.), but that are frequently debt) to earnings before interest and
present in small companies on the Serbian taxes,
market and on similar markets. • M V IC/EBITDA (Market Value of
Invested Capital to EBITDA) – Market
Appendix 1: The Most Common Market value of invested capital to earnings
Multiples before depreciation, amortization,
interest and taxes,
Market multiples are ratios between selected • MVIC/S (Market Value of Invested
level of market value (equity, firm value, Capital to Sales) – Market value of
enterprise value, other variations) and invested capital to revenue.
appropriate level of income stream (revenue,
EBIT, EBITDA, net income, cash flow, etc.) Market multiples could relate to different
or assets (book value of equity, tangible book time intervals: last fiscal year, last twelve
value etc.). In some industries, it is useful months, next twelve months, etc. To be
to develop multiples based on some natural precise, time intervals relate to denominator,
indicator (e.g. capacity in GWh for power while value is nominator should be as at the
plants, number of rooms for hotels etc.). last day of that interval, i.e. valuation date.

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International Journal for Traffic and Transport Engineering, 2015, 5(1): 17 - 28

Application of multiples is very simple – where:

calculated market multiple multiplies with DR E – discount rate applicable to net income,
amount of appropriate earnings stream or g E – long term growth rate of net income
assets of valuation subject which must be (more precisely, earnings per share) in
from same time interval as multiple. Any indefinite future period.
inconsistency leads to significant results
distortion. Other fundamentals could be analyzed in
similar way. For more details see Fernandez
Appendix 2: Relationship between (2013).
Multiples, Capitalization Rate and
Discount Rate Appendix 3: WACC Definition and
Components
W hen it is expected that some level of
ear nings wou ld grow at the constant Discount rate is the rate which converts
sustainable rate in indefinite future period company’s cash f lows into the value of
it is possible to transform its annual amount capital. Depending of the sources of cash
into value of flow’s generator (source) using flow, discount rate could be related either to
appropriate capitalization rate. In case of equity or to the invested capital (also some
net income, capitalization would result in of its variations, firm value or enterprise
value of equity. value). In more general case, when cash flows
before debt service (formerly called debt-
free cash flows) are subject of discounting,
(8) the appropriate discount rate is Weighted
Average Cost of Capital (WACC), usually
where: presented as:
Vs – value of subject company’s equity,
E s – earnings (net income) of subject
company,
CR E – capitalization rate of earnings. (11)

On the other hand, equity value could be where:

calculated applying market P/E multiple to rE – cost of equity, i.e. required rate of return,
the subjects company’s earnings: r f – risk-free rate, i.e. rate of return of the
least risky investments (usually government
bonds),
(9) β – beta coefficient, measure of systematic
risk,
It follows from the above that P/E is in ERP – market risk premium for investing
fact reciprocal value of capitalization rate in equities, the difference between return
applicable to earnings. As capitalization rate on market portfolio of equities and the risk-
is equal to discount rate reduced for implied free rate,
growth, the following identities hold: CRP – country risk premium,
SCR – specific company risk,
(10) rD – cost of debt, pre-tax,

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 Milenković N. Market Multiples Adjustments for Differences in Risk Profile – An Airline Company Example

E – equity, Hitchner, J.R. 2003. Financial Valuation - Application and

D – debt (usually interest-bearing), Models, John Wiley & Sons.
V – invested capital (E+D),
E/V – equity share in invested capital, IATA 2014. Economic Performance of the Airline
D/V – debt share in invested capital, Industry (2014 mid-year report). Available from
t – tax rate. Internet: <www.iata.org/economics>.

The cost of equity in the above relation is Ivashkovskaya, I.; Kuznetsov, I. 2007. An Empirical
determined by modified CAPM method. Study of Country Risk Adjustments to Market Multiples
W hen beta is omitted, relation becomes Valuation in Emerging Markets: the Case for Russia, Эл
“build-up” method, sometimes easier to ектронныйжурналКорпоративныеФинансы, 3: 26-52.
obtain data for. However, specific company
risk assessed within build-up method should Mercer, Z.C. 2013. Fundamental Adjustments to Market
include industry risk and possible other risk Capitalization Rates, reprinted from Mercer Capital’s Value
factors usually captured by beta. Metters TM 2004-11. Available from Internet: <http://
mercercapital.com>.
As already mentioned, discount rate is
usually applied to cash f low. When other Pearce, B. 2013. Profitability and the Air Transport
earnings measure is to be discounted (as in Value Chain, IATA Economics Briefing No 10. Available
Appendix 2), appropriate adjustments are from Internet: <www.iata.org/economics>.
required.
Peek, E. 2014. A Study of Differences in Returns between
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