Valuation Multiples: Why Do We Use Them & How [Video]
Multiples is a term widely used in lots of valuation theories.
But why do we use valuation multiples?
We assume that a peer group of comparable firms for which the market value is available can be used as a proxy for the valuation of the company we are evaluating right now.
The multiple is a ratio, composed of two variables. In the numerator you have the valuation and in the denominator you could have many different variables, but in the majority of the cases you have the EBITDA.
Two really important valuation multiples are often mentioned:
1| EBITDA multiple
The EBITDA stands for earnings before interest, taxes, depreciation and amortization. This is calculated by subtracting operating costs from revenues.
So the multiple is the result of the valuation divided by EBITDA.
When you take the multiple of comparable companies, you compare it to your valuation. If on one hand you have valuation/EBITDA and on the other hand you have X/EBITDA, you then find the multiplication of the multiple by the EBITDA of your company. The result is your valuation.
The alternative of the EBITDA is EBIT. This stands for Earnings before interest and taxes.
The reason why EBITDA is more widely adopted is that it is a proxy for the operating cash flows of the company. Operating cash flows are key in any valuation model based on discounted cash flows (DCF).
Another way to think about it is that the EBITDA is a proxy for the operating profitability of the company. Let’s take an example:
If a company has a negative EBITDA but a positive profit, the profit is not generated by the operations of the company. Instead, the profit is generated by extraordinary items, i.e the disposal of an asset. This income contributes to your profit, but it doesn’t say that the company is healthy.
How do we build a multiple?
You need to have a group of comparable firms. The most common practice is to use public companies for two reasons
– there is data available for their valuation, operating performance etc.
– state of stability
In a certain point of your projections you have a moment when the company is going to reach a state of stability. When you make this assumption, public companies are the most suitable proxy for a company that reached a steady state.
It can be the case that you want to use private companies, but it is going to be hard to find good data.
Once you have identified a group of companies, you can find the data about the market capitalization and the EBITDA. In most cases you use last year’s EBITDA.
Alternatively, you can use the forward-looking EBITDA, in which case you get the forward-looking multiple. This means you are using the EBITDA that is projected for the company. There is little difference between the two.
You can find the market capitalization on any site for stock information. You can also find it by multiplying the share price by the number of shares outstanding.
For every company that you have identified you take the market capitalization divided by the EBITDA. Then you find the average of all multiples and that is the target EBITDA multiple that you are going to use for your company.
There are several scenarios from here forward. The most basic one is you multiply the multiple by the last year EBITDA of your company. As a result you get your valuation.
In most of the cases, you make a horizon of projections where you calculate the potential cash flows of the company on an annual basis. Only then you use the multiple to calculate the terminal value. The reason to do this is that you cannot do annual projections on a year per year to infinity.
The reason behind doing the projections, is because during this period the company is going to undergo significant changes until the point where you assume that it’s going to reach the steady state. This is a widely adopted assumption in the valuation theories.
2| P/E ratio
The price to earning ratio is the price per share divided by the earnings per share. The earnings per share are the profit of the company divided by the number of shares outstanding.
This means that the multiple is equivalent to the market capitalization divided by profit. Even though there can be differences between the earnings that get to the shares and the actual profits, these are limited cases.
The reasons why most valuation firms are not fans of this type of multiple is that profit is an accounting figure that is easily adjustable. We have said before that profit is an opinion and cash is king. Profit is an opinion because it’s the result of various calculations that is easily influenced.
Hence, the EBITDA multiple is preferred by valuation firms.
What is your experience with calculating multiples? Did you know about the difference between the two types of multiples? Let us know in the comments!