Understanding Valuation Multiples: A Guide
What are Valuation Multiples?
Everyone in the world of startups and investing talks about valuation multiples. What are valuation multiples, and what do they mean when assessing an investment business? Valuation multiples are a series of ratios that reflect the implied market value of companies in relation to a specific operating metric. These quick comparisons give insight into particular business KPIs and facilitate rough comp analysis among peer companies with different characteristics, most notably size. Valuation multiples are used to standardize a company’s value per unit and are many investors’ favorite method of assessing company value for their speed and simplicity. AVGI delves into the topic of valuation multiples, discussing the different types of multiples, how to calculate multiples, and when not to use multiples.
2 Types of Valuation Multiples
There are several different valuation multiples, but they all fall into two categories: Enterprise value multiples and Equity value multiples. Each type of multiples analysis reveals different insights about the company in question. Analyzing multiples from both categories will yield a more robust understanding of the company’s finances and direction.
Enterprise Value Multiples
Enterprise valuation multiples reveal the rating of a business independently of its capital structure. These multiples are crucial for providing a comprehensive picture of a company’s valuation by incorporating all forms of capital, including debt and equity. By focusing on enterprise value, investors can roughly assess the value of a company as a whole rather than just its equity portion. This approach allows for a more accurate comparison of companies across different capital structures and industries, which can provide further insights.
Enterprise value multiples are particularly useful in the research stage of finding a target company for mergers and acquisitions. They help assess a company’s total value, including its liabilities and cash reserves. Investors looking to acquire entire businesses rather than just equity stakes will use enterprise value multiples to assess potential target companies. Additionally, enterprise value-based multiples can provide insights into a company’s operational efficiency and growth potential, making them valuable for internal reviews and strategic decision-making.
Some examples of enterprise value multiples include the enterprise-value-to-sales ratio (EV/sales), EV/EBIT, and EV/EBITDA.
Equity Multiples
Equity multiples explore the relationship between a company’s share price and an element of the company’s performance, such as earnings, sales, or book value. In contrast to Enterprise Multiples, which examine the company as a whole, Equity Multiples break down the company’s components to examine the details in more depth. These multiples are most relevant when investors look to acquire minority shares in companies. Additionally, they offer detailed insights into the company’s particular strengths or weaknesses, which help conduct internal reviews and identify value drivers.
It is crucial to understand that capital structure makes a difference in equity multiples because different debt levels affect the results. Therefore, it is essential not to try comparing capital-intensive businesses with low-debt businesses, as that could lead to inaccurate and misleading conclusions.
Historical vs Forward-Looking Multiples
Multiples can also be historical, describing past company performance, or forward-looking, predicting future performance based on past data. Historical valuation multiples are usually calculated over the last twelve-months (LTM). Forward-looking multiples are more useful for firms with complex financial structures or those with limited historical data. That’s why multiples are a favorite way for startup investors to discuss the value of startups.
Calculating Valuation Multiples
Formula and Components
Valuation multiples are ratios that consist of two components: a numerator and a denominator. The numerator will always be a measure of value, such as value or enterprise value. In contrast, the denominator will be a financial (or operating) metric, such as net income or sales.
The basic formula for valuation multiples looks like this:
Valuation Multiple = Value Measure ÷ Value Driver
The denominator can also include metrics such as free cash flow, which represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Calculating the Denominator (EBITDA, Net Income, etc.)
The denominator may be either a stock or a flow, with a focus on flows in this discussion. Historical valuation multiples are usually calculated over the last twelve month (LTM) period. To calculate the LTM EBITDA, add the EBITDA from the most recent stub period to the latest full-year EBITDA, and subtract the EBITDA from the corresponding stub period last year. Other important financial metrics that can be used in the denominator include cash flow, which is crucial for assessing a company’s operational performance and market value.
Valuation Multiples in Practice
Valuation multiples are widely used in practice by investors, analysts, and companies to estimate the value of a business. They provide a quick and simple way to compare the value of similar companies and to estimate the value of a company based on its financial metrics. In this section, we will discuss some examples of how valuation multiples are used in practice
Comparable Company Analysis
One common use of valuation multiples is in comparable company analysis (“Comps”). Comps involves identifying a peer group of comparable companies and calculating their valuation multiples. A peer group is a set of companies or assets that are selected as sufficiently comparable to the company or assets being valued. The investor will attempt to draw comparisons between the company being valued and the peer group companies to gain meaningful conclusions about the company’s market performance and competitive positioning.
Analysts often compare the market values of comparable companies to estimate the worth of the target company. The median or average valuation multiple of the comparable companies is then used to estimate the value of the target company. For example, if we are valuing a company in the retail industry, we might identify a group of comparable companies such as Walmart, Target, and Costco. We would then calculate their price-to-earnings (P/E) ratios and use the median P/E ratio to estimate the value of the target company. In practice, no two businesses are alike, and analysts will often adjust the level of value of observed multiples to attempt to harmonize the data into a more comparable format. These adjustments can involve the use of regression analysis against different potential value drivers and are used to test correlations between the different value drivers.
Precedent Transaction Analysis
Another use of valuation multiples is in precedent transaction analysis (Precedents). PTA involves identifying a group of similar companies that have been acquired in the past and calculating their valuation multiples at the time of acquisition. The median or average valuation multiple of the precedent transactions is then used to estimate the value of the target company. For example, if we are valuing a company in the technology industry, we might identify a group of similar companies that have been acquired in the past, such as Facebook’s acquisition of Instagram. We would then calculate the valuation multiple of the precedent transaction and use it to estimate the value of the target company.
Valuation multiples are also used in calculating the enterprise value of a company. Enterprise value is the total value of a company’s debt and equity, and it is often used as a measure of a company’s size and scope. Valuation multiples such as the enterprise value-to-EBITDA (EV/EBITDA) ratio are commonly used to estimate the enterprise value of a company.
The Main Advantage and Multiple Disadvantages of Valuation Multiples
The main advantage of using valuation multiples to assess a company’s value is the fact that they provide quick and easy numbers and give insights that are easily understood. However, there are several significant disadvantages that are important to note:
Multiples are overly simplified ways to measure value. Each ratio only compares two factors at any given time when, in actuality, numerous factors are at play at all times, affecting the company value in real time. Isolating two factors to compare and drawing conclusions based on those isolated factors gives an inaccurate picture of the company’s actual performance and value.
Multiples are influenced by the company’s capital structure. This influence can lead to significant variations in the valuation results, as different companies may have vastly different capital structures, such as varying levels of debt and equity. For instance, a company with high leverage might appear undervalued when using specific multiples, while a company with less debt might seem overvalued.
Differing accounting policies can skew multiples. Companies may adopt different methods for recognizing revenue, valuing inventory, or depreciating assets. These accounting differences can lead to discrepancies in reported earnings and other financial metrics, making it challenging to draw accurate comparisons between companies. As a result, investors must exercise caution when using multiples to ensure they are comparing companies with similar capital structures and accounting practices. This requires a deep understanding of the underlying financial data and the ability to adjust for any discrepancies that may arise. By doing so, investors can better evaluate companies and make more informed investment decisions.
Multiples are a snapshot frozen in time of how a company is performing. It does not change dynamically based on evolving market influences and is not an accurate indicator of long-term value. Multiples are only good for short-term value analysis.
Multiples are sensitive to the choice of comparable companies and the calculation of the valuation multiple. A significant outlier can skew the results and reliability of the industry multiple, impeding valuation analysis.
However, ease and convenience are powerful drivers, and together, the existence of wide-ranging comparables helps explain the enduring use of multiples by investors despite their significant disadvantages.
Best Practices for Using Multiples
To overcome these limitations, it is important to follow best practices when using valuation multiples.
Use a large and diverse group of comparable companies to calculate the valuation multiple. This can help to reduce the impact of any one company’s data on the calculation of the valuation multiple.
Use several valuation multiples to estimate the value of a company. This can help to provide a more comprehensive view of the company’s value and to reduce the risk of relying on a single valuation multiple.
Consider the capital structure of the company when using valuation multiples. Companies with high levels of debt may have different valuation multiples than companies with low levels of debt. Therefore, it is important to adjust the valuation multiple for the capital structure of the company.
Applying Valuation Multiples
Valuation Multiples Examples in M&A Transactions and IPOs
Valuation multiples can be used to estimate the value of a company by comparing it to similar businesses that have been acquired. For example, let’s consider the technology industry, specifically a software company. Software companies often use the EV/EBITDA multiple to determine their value.
Suppose a software company, TechInnovate, has an EBITDA of $10 million. If similar companies in the same industry have an average EV/EBITDA multiple of 15x, TechInnovate’s estimated enterprise value would be calculated as follows:
Enterprise Value = EBITDA x EV/EBITDA Multiple
Enterprise Value = $10 million x 15 = $150 million
In this case, the business metric used is EBITDA, and the multiple is derived from comparable companies within the technology sector. The numerator in this calculation is the enterprise value, which provides a holistic view of the company’s worth, including its debt and equity. In addition to EBITDA, other metrics, such as invested capital, can provide insights into a company’s financial health and performance.
Why Valuation Multiples Differ Across Industries
Different industries have different profit margins, operating models, and growth rates. For example, grocery market chains may have low profit margins but steady revenue streams and positive growth rates, versus ski resort chains, which may have much higher profit margins but fluctuating revenue streams and growth rates due to their more seasonal business model.
In industries such as transportation, rental costs are often added back to EBITDA when calculating the EV/EBITDAR multiple, highlighting the importance of understanding these costs in financial valuations. Different markets also have different growth rates, so it’s important to use valuation multiples only in the right context to draw meaningful conclusions. Valuation multiples are an excellent quick way to give you a sense of how similar businesses compare in value.
Importance of Understanding Valuation Multiples
Valuation multiples can help your team understand a number of things, including the value of your business, its strong points and value drivers, and its weaknesses that need improvement. Valuation multiples are the choice language of investors, so if you are seeking funding for your startup company, be sure to familiarize yourself with your company’s valuation multiples and what the norms are for your industry. Be prepared to discuss the method you used to determine your company’s valuation to back up your numbers with evidence. Understanding valuation multiples is crucial for companies, investors, and analysts to make informed decisions.
When Not to Use Valuation Multiples
As we have discussed, valuation multiples are quick ways to measure value but have significant limitations. These limitations render them inadequate for anything more than an internal review, casual discussion, or beginning stage research. Any application in which the value of a company makes a material difference is a situation in which the company value should be calculated more precisely than with a valuation multiple. Multiples provide estimates of value, which are useful for gaining a general sense of a company’s standing. However, the details make all the difference in a company’s value, particularly when the stakes are high, and empirical precision is necessary in litigation, business transactions, and tax cases.
Over 30 years of business valuation experience, our team has witnessed firsthand how slight differences in valuation conclusions can translate into hundreds of millions of dollars saved or lost for the client. With the high stakes, there is no room for vague guesses, only surgical precision.
That’s why our professional recommendation is for an owner or potential investor to obtain a full-scope business appraisal if they are serious about selling or buying a business, facing litigation, or need a valuation for tax purposes. Contact AVGI today to discuss your valuation needs.
