What are valuation multiples and what's their role in the valuation process?
Please keep in mind - This post is a 'once over lightly' of the subject, but even so it's difficult to discuss valuation multiples without giving some context on valuation approaches, etc. I've tried to pitch this for readers who are less familiar with the concepts, but still useful for those who are familiar with valuation. Please let me know if you think I've gotten that balance wrong.
If you've just visited the Valuation Multiples page you may be wondering about their calculation, uses as a valuation benchmark, and their limitations.
First-up: Why are Valuation Multiples important?
You may be the owner, and/or leader of, a privately owned business - in which case you may be wondering why the valuation multiples of publicly listed companies are relevant to you. Here's the thing - normally there's no way to directly observe the value of a privately owned business. The only time this value is really tested in the market is when there is a transaction and even then the details may not be reported, or the transaction may have taken place years ago, making it less relevant. Valuation Multiples of publicly listed companies can provide a useful benchmark. Of course, there are some limitations you should be mindful of - which is the purpose of this post.
Valuation Multiples are also relevant to the directors and managers of publicly listed companies. For listed companies with a number of divisions operating in different industry segments it can be useful to benchmark their component value to other external 'pure play' industry competitors. In planning for an acquisition or a divestment of a non-core business reviewing Valuation Multiples can provide a gauge as to potential pricing.
What is a valuation multiple?
At its simplest a valuation multiple is a ratio of two numbers - a valuation metric in the numerator and a financial measure (or operational measure) in the denominator, like this:
In this case our valuation metric in the numerator is Enterprise Value (EV) and the financial metric in the denominator is Earnings Before Interest Tax Depreciation and Amortisation (EBITDA). Examples of other common valuation multiples include:
p/e - price of a share / earnings per share (or Market Capitalisation / Net Income)
p/book - Market Capitalisation / Common Equity
EV/EBIT - Enterprise Value / Earnings Before Interest & Tax (EBIT)
EV/Revenue - Enterprise Value / Revenue
Note - There are also industry specific multiples (beyond the scope of this post)
How are they calculated?
Most often valuation multiples you see reported relate to companies who have equity publicly listed on an exchange, such as the Australian Stock Exchange (ASX) or New Zealand Stock Exchange (NZSE). In these cases the valuation metric in the numerator of the multiple will be based, at least in part (i), on the market value of the company's equity traded on the relevant exchange. The financial metrics used in the denominator (e.g. EBITDA) are drawn from the financial reports disclosed by the company or from the expectations of analysts covering the stock. When you look at analysis detailing valuation multiples it's important to understand the basis of the calculation, i.e:
As at Date - The point in time of the valuation metric used in the numerator (is it based on the most recent share price, a specified valuation date or an average of some time period. The market moves, so looking at old multiples can be misleading.
Trailing or LTM - This denotes that the financial metric in the denominator is based on a trailing reported period (e.g. the last financial year), or Last Twelve Months (LTM) e.g. aggregating the last four quarters.
Forward or NTM - These terms indicate that the financial metric used in the denominator is based on a forecast (most likely the median or average of published research reports put out by analysts at large investment banks).
Trading or Transaction - These words refer to the type, or source, of the multiple, i.e. is it based on publicly listed companies (trading on an exchange) or private M&A activity (transactions). Note that the information presented on the Valuation Multiples page are trading multiples of publicly listed companies.
(i) Enterprise Value is a function of the market value of the equity (market cap) + Net Debt + Minority Interests + Preferred Equity, as sourced from the Balance Sheet.
How are Valuation Multiples used in the Valuation Process?
The answer to this question depends on the valuation approach being applied, two common ones being:
Income Approach. This involves estimating the forecast free cash flows of the business and calculating a Net Present Value (NPV) by applying a discount rate which reflects the expectations of the investor and the risk of realising those future cash flows. Practitioners following this approach generally build a Discounted Cash Flow (DCF) model and use a Weighted Average Cost of Capital (WACC) as the discount rate. This approach is often preferred as it considers the specific value drivers of the company being valued. Such drivers can include the revenue model, variable and fixed costs, capital expenditure, and working capital of the business. The challenge is that deriving the forecast involves making assumptions about the future, which is always challenging.
Relevance of Valuation Multiples to this approach. Valuation Multiples (of publicly traded companies and private transactions) are an invaluable cross-check or 'sense check' of the value estimate. It's important to compare 'like to like', so a DCF calculated result would generally be compared to an Enterprise Value multiple.
Market Approach. This approach uses the prices observed for comparable publicly listed companies and/or private transactions as a benchmark to the value.
Relevance of Valuation Multiples to this approach. The public companies and private transactions used as reference points may be much larger (or smaller) than the company we are seeking to value, so a Valuation Multiple of a key financial metric is applied. In other words the Valuation Multiple is a key component of this approach.
Other approaches include methods such as Future Maintainable Earnings, Cost Approach, and Adjusted Net Asset Value. This is a subject I'll come back to on a future post.
Limitations
Valuation Multiples are a useful part of the valuation process, but there are some important limitations (and mitigation) to keep in mind:
No two companies are exactly alike. It can be difficult to find 'pure play' listed companies which are directly comparable to a client's business. Usually there are differences in operational focus, size, or the country jurisdiction in which they operate. So Valuation Multiples should be used with judgment (which comes from experience).
Wide Ranges. Even within a specified industry group a sample of Valuation Multiples can appear as a wide range. You may have noticed that the charts on the Valuation Multiples page only show the inter-quartile range (25th to 75th percentile), i.e. the middle 50% of results. A more refined approach involves gauging the relevant point in the range by considering one or more other financial metrics (thereby increasing comparability). One method to do this is to produce a scatter plot of the multiples versus an explanatory variable and using the 'line of best fit' to estimate an appropriate multiple. This is a technique I've used many times. Please keep an eye out for future posts.
Comparability to Private Companies. There are important differences to owning all or part of a private business compared to a share of a publicly listed company. If you own a share of a listed company you can generally sell it at short notice into a liquid market, however for a private company it can take time to sell. Moreover, if you are a minority shareholder in a private company perhaps there are limitations on who or when you are able to sell the shares. Factors such as marketability / liquidity and level of control can mean that the Valuation Multiples of public companies may not be directly comparable to that of a similar private company. Valuation analysts attempt to take this into account by applying a discount or premium, depending on the specific circumstances.
Summary
In this introductory post I've discussed the calculation, uses and limitations of Valuation Multiples.
If you've read this far - thanks for your time, I appreciate it. If you'd like to receive notification of future posts and updates to the information on this website please subscribe.
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