AN ANALYST’S GUIDE TO SECTOR-SPECIFIC OPTIMAL PEER GROUP VARIABLES AND MULTIPLES IN THE SOUTH AFRICAN MARKET

Abstract

(ProQuest: ... denotes formulae omitted.)1. IntroductionThe investigation in this paper primarily aims to establish which multiples perform the most accurate equity valuations in each of the sectors in the South African market. A sector-specific approach to multiples seems intuitively logical. For example, one might anticipate that asset-based multiples may be more appropriate in capital-intensive industries, compared to consultancy-based industries. However, a number of underlying questions lie embedded in a sector-specific approach:Firstly, apart from investigating whether empirical evidence exists to support the common practice of using industry-preferred multiples, it is anticipated that these preferences may not be based on optimal peer group variables (PGVs). Therefore, one has to ascertain whether, and how, a sector-specific-based approach will affect the peer group selection process.Secondly, based on the results from the first question, it is envisaged that one will have to re-evaluate the precision of the multiples. From the latter one will be able to ascertain which specific multiples produce the most accurate valuations in which sectors.Thirdly, do these sector-specific superior multiples perform the most accurate valuations in the respective sectors consistently over time? Fourthly, what is the magnitude of the opportunity cost involved when employing suboptimal multiples, i.e. does a sector-specific approach to multiples-based valuations matter?The emerging market literature offers little insight into these issues. In addition to addressing these issues, this study offers two important contributions to the topic of multiples-based valuations: Firstly, it offers empirical evidence on the valuation precision of sector-specific multiples, whose peer groups were compiled based on optimal, sector-specific, PGVs. At present, empirical guidance on the valuation performance of multiples whose peer group selection was based on optimal, sector-specific, PGVs does not exist. In fact, the scant extant literature in this respect ignores the unique value contribution that sector-specific peer group selection has to offer. Instead, the current literature offers a suboptimal solution, since it evaluates the valuation precision of multiples based on a generic peer group selection basis, such as industry classification or valuation fundamentals.Secondly, when performing valuations, whether relative or intrinsic in nature, multiples, or other key variables, of sector-specific benchmark companies are typically identified as a starting point, prior to the adjustment of these variables. However, key to the identification of these benchmark variables is an understanding of the preferable variables for each of the sectors. However, the literature currently does not offer much guidance in this respect. It is envisaged that this paper will offer an empirical guide to analysts in this respect. Consequently, the final results are presented in a Sector Value Chain (SVC), which offers a guide to analysts in terms of the optimal choice of a sector-specific PGV and an accompanying, sector-specific, optimal multiple for companies residing in each of the 28 sectors that are analyzed.2. Literature ReviewPopular belief suggests that different industries have different multiples (Liu et al., 2002a). In a study conducted on UK and European industries, Fernandez (2001) found that analysts have a preference for certain multiples in certain industries, which supports the notion that different multiples are best suited to different industries. A similar conclusion was drawn by Abukari et al. (2000) in a study of equity valuation techniques based on companies listed on the Toronto Stock Exchange.Although, in practice, different multiples are regarded as best suited to different industries (Schreiner, 2007), the literature offers surprisingly little evidence in support of this phenomenon. …