Ann: Skilled Group to be acquired by Programmed, page-39

"...how can we make an educated estimate regarding what P/E & EV/EBITDA multiples investors will be happy to pay for a particular business?"

hasnainj,

Apologies for the tardy response.

The question you have asked encapsulates the pure essence of investing in publicly listed equities.

Unfortunately the answer is so complex that no HotCopper post would be able to do it justice, so I won't bother trying too hard, save to say that there will be almost as many answers to your question as there are individual market participants.

Which means that there can never be any definitively right answer.


But broadly, the rating of a stock (i.e., it valuation multiples) is proportional to:

- the quality of its business model (pricing power and relative competitive position, degree of customer concentration and supplier dependency, degree of differentiation of product or service offering, product life cycle and obsolescence risk)


- its management (strength and depth, strategic track record, incentivisation, alignment with shareholder interests),

- its financial track record over time (revenue and earnings growth, earnings stability and resilience during economic downturns),


- its financial pedigree (ROE, operating margins, capital intensity, organic growth trajectory, Free Cash Flow, financial leverage (i.e., level of indebtedness), dividend policy and track record),

- position in the business, or equity market, cycle, and

- company size and stock liquidity.


This by far not a comprehensive list of factors that most market participants consider, to greater or lesser degrees, when forming a view of how much they would like to pay for as a multiple of a company's earnings.

So, the list is far more indicative than it is prescriptive and clearly there will be a great deal of relative subjectivity involved when different people consider different factors.


Nowhere is this relative subjectivity more evident than in the case of this PRG-SKE merger scenario, where I have to eat a nice big serving of humble pie having got it completely wrong.

Clearly the merged company will not be the world's most pre-eminent company (verily, it is no CSL or CBA, or COH); indeed I'd rate it no higher than a 6 out of 10 on most of the factors listed above, which "feels" to me like a 30% to 40% discount-to-market valuation multiple is fair and reasonable (i.e., and P/E of 11 times or 12 times, compared to the current overall market multiple of around 17.5 times).

Well, the market collected has decided that view of mine to be excessively generous, and - based on my pro forma modelling for the merged company, given the aggressive way the pair have been sold off after PRG went ex-dividend - the see-through multiple for the merged company is now currently trading on a P/E of just 7.0 times (based on FY16 forecasts).

Now I can stand on my head and whistle Tom Dixie out of my behind until the cows come home that 7.0 times P/E (less than half the overall market multiple) is too cheap... if you think you are right, and the market is wrong, well, then - simply - it is you that is wrong.

So here, with this PRG-SKE situation, is a real-time example of to what extent the "discerning" of an appropriate valuation multiple is - to a large extent - more art than science.


(Footnote: When I get things wrong, I always try to learn from my errors. in this case the mistake I made was to underestimate to what extent some original PRG shareholders would demonstrate a distaste for their company buying what they probably think is an inferior business with a lot of debt. Also, I think that the scope for cash leakage due to any special dividend that the SKE board might declare might have also created uncertainty for PRG holders.)