What are Valuation Multiples and How Do Investors Use it

Senior executives know that all valuation methods are not equal. Any analysis is only as accurate as of the forecasts it relies on. One such analysis is the valuation multiples technique.

 

Firms still use the multiples analysis. Despite it being the oldest technique in valuation. Yet firms often misunderstand and misapply this method.

 

In this article, we will present a clear picture of valuation multiples. We will dispel all misconceptions and show you how it can be a powerful valuation tool.

 

What are the valuation multiples?

 

Valuation multiples are financial measurement tools. They check one financial metric as a ratio of another. This makes different companies more comparable.

 

They are the proportion of different financial metrics. E.g., Share price to Earnings per share. It is an easy way to compute a firm’s value. It helps to compare it with other businesses.

 

The valuation approach assumes that a ratio is applicable. The ratio applies to firms operating within the same business or industry line.

 

In other words, when firms are comparable, investors use this approach. It helps to determine the value of one firm based on the value of another.

 

It captures a firm’s operating and financial characteristics in a single number. You can multiply it by a specific financial metric (e.g., EBITDA) to yield an enterprise or equity value.

 

Common Ratios Used in the Multiples Approach

 

The two categories of valuation multiples are enterprise value multiples and equity multiples. Enterprise value (EV) multiples include EV/sales, EV/EBIT, and EV/EBITDA.

 

Equity multiples involve examining ratios. The ratios are between share price and an element of the company’s performance.

 

This includes earnings, sales, book value, or something similar.

 

Equity multiples include the price-to-earnings (P/E) ratio and price-earnings to growth (PEG) ratio. Some other common ratios are the price-to-book ratio and price-to-sales ratio.

 

A change in capital structure can impact equity multiples. This is true even when there is no change in enterprise value (EV).

 

Enterprise value multiples allow for a direct comparison of different firms. This is regardless of capital structure. Thus they are better valuation models than equity multiples.

 

Enterprise valuation multiples are less affected by accounting differences. This is since the computation of the denominator is higher up on the income statement. 

 

But investors use the equity version more. This is because they are easy to calculate. They are available via most financial websites and newspapers.

 

Steps to Conduct a Multiples Analysis

 

The process of valuation using multiples involves specific steps, and they are:

 

1. Identify similar or comparable assets. Gather market values for these comparable assets.

 

2. The market values of the assets are converted into standardized values. These are relative to a key statistic as it is not possible to compare absolute prices. This process of standardization creates valuation multiples.

 

3. You will apply the method to the asset’s key statistics. It controls differences between the valued asset and the comparable assets. Otherwise, the assets may affect the multiple.

 

Multiples Used in a Multiples Analysis

 

You can classify multiples used in multiples analyses into two. These are enterprise value multiples or equity multiples. The most common equity multiple is the P/E ratio – or the price per earnings ratio.

 

The most common enterprise value multiple is EV/Sales. Another one of its terminologies is the enterprise value per net sales ratio.

 

Firms often use equity multiples in equity valuation. Rather than the enterprise value multiples, investors are more familiar with these.

 

Enterprise value multiples are more comprehensive. They have more available multiples.

 

These multiples allow analysts to focus on crucial statistics. These minimize differences in accounting policies.

 

What are the different types of valuation multiples?

 

There are two main types of valuation multiples:

 

• Equity multiples or Market multiples

 

Investment decisions make use of equity multiples. This is especially when an investor aspires for minority positions in companies.

 

Here are some common equity multiples.

 

• P/E Ratio

 

It is the most used equity multiple. The needed data is very accessible. It is the proportion of Share Price to Earnings Per Share (EPS)

 

• Price/Book Ratio

 

It is useful if assets drive earnings. It is the proportion of Share Price to Book Value Per Share

 

• Dividend Yield

 

It helps in comparisons between cash returns and investment types. It is the proportion of Dividend Per Share to Share Price

 

• Price/Sales

 

Firms that make losses use this method usually. Firms can use it for quick estimates. It is equal to the proportion of Share Price to Sales (Revenue) Per Share

 

But a financial analyst must consider that companies have varying levels of debt. These influence equity multiples.

• Enterprise Value (EV) multiples

 

Enterprise value multiples are the appropriate multiples for mergers and acquisitions. Here are some common enterprise value multiples.

 

• EV/Revenue

 

Differences in accounting affect it a little. It is equal to the proportion of Enterprise Value to Sales or Revenue.

 

• EV/EBITDA

 

Usually, the hotel and transport sectors use it. It is equal to the proportion of Enterprise Value to Earnings before deductions. Deductions are Interest, Tax, Depreciation & Amortization, and Rental Costs

 

• EV/EBITDA

 

EBITDA is a substitute for free cash flows. It is the most used enterprise value multiple. It is equal to the proportion of EV to EV / Earnings before deductions.

 

• EV/Invested Capital

 

Capital-intensive industries use this method. It is equal to the proportion of Enterprise Value to Invested Capital.

 

There are more enterprise and equity enterprise value multiples used in company valuation. This article only presented the most common ones.

 

More readings and understanding of each multiple and related concept can help analysts. It helps them to better apply multiples in making financial analyses.

 

What are the different methods of valuation multiples?

 

There are two methods of performing analysis using multiples.

 

• Comparable Company Analysis

 

This method analyzes public companies. These companies are like valued companies.

 

An analyst will gather some details for each company. This includes share prices, market capitalization, capital structure, revenue, EBITDA, and earnings.

 

• Precedent M&A Transactions

 

It analyzes past mergers and acquisitions (M&A) in the same industry. Investors can use it as a reference point for the valued company.

 

Advantages of valuation multiples

 

• Using multiples in valuation analysis helps to make sound judgments. This is because they provide valuable information about a company’s financial status.

 

• Furthermore, they are relevant because they revolve around crucial statistics. These relate to investment decisions.

 

• Finally, the simplicity of this method makes it easy to use for most analysts.

 

Disadvantages of valuation multiples

 

• The simplicity of multiples is also a disadvantage. This is because it simplifies complex information into a single value. This simplification can lead to misinterpretation. It makes it challenging to break down the effects of various factors.

 

• Multiples represent a single instance of a firm’s status. They do not represent a period. As such, they do not show how a company grows or progresses.

 

• Multiples reflect short-term data instead of long-term. Thus, the values may only be applicable in the short term.

 

Principles of Valuation Multiples

 

• Valuation is the projected or current worth of a firm

 

The valuation is the ‘price’ of the business.

 

A founder has a product to sell (their company). Investors want to buy that product.

 

The valuation is the price the investor agrees to pay now for shares (a ‘piece’ of ownership) in a company.

 

The investor may pay more than the company is worth today. But that depends on the investor’s preferences and alternatives.

• Valuation as mature firm is the aim

 

There are standard evaluation techniques for mature firms. These have been operating for several years with stable cashflows. Four of the most common techniques include

 

• comparable analysis
• previous transactions
• discounted cash flow
• P/E ratio

 

The well-tempered multiple

 

Some basic principles can help companies apply this method. 

 

• Use peers with similar prospects for growth and ROIC

 

It is challenging to find the right firms for the comparable set. The firm might list its competitors in its annual report.

 

Firms can also use the Standard Industrial Classification codes. The US government publishes it.

 

A better system is the Global Industry Classification Standard (GICS). It has been recently developed by Morgan Stanley Capital International and Standard & Poors.

 

The real digging begins with this initial list of comparables. You must examine each firm on the list. Answer some critical questions.

 

Why are the multiples different in the peer group? Do individual companies have a superior value proposition? Do they have better access to customers, recurring revenues, or economies of scale? 

 

• Use forward-looking multiples

 

Both the valuation principles and empirical evidence lead us to a recommendation. It is that forecast determines multiples rather than historical profits.

 

Sometimes, no reliable forecasts are available, and you must rely on historical data.

 

Then make sure to use the latest data possible and cut one-time events.

 

Forward-looking multiples are more accurate predictors of value.

 

• Use enterprise-value multiples

 

P/E multiples have two significant flaws.

 

First, capital structure affects them.

 

Second, earnings determine the P/E ratio. This includes many nonoperating items, such as restructuring charges and write-offs. These are often one-time events. So, multiples based on P/Es can be misleading.

 

AOL Time Warner wrote off $100 billion in intangibles in 2002.

 

It is EBITA (earnings before interest, taxes, and amortization) was $6.4 billion. But it still recorded a $98 billion loss.

 

Since earnings were negative, its P/E ratio was not meaningful.

 

The ratio of enterprise value to EBITA is one alternative to the P/E ratio. This ratio is less susceptible to manipulation by changes in the capital structure.

 

DCF vs Multiples

 

The multiples method is simple. Investors can get their results. They only have to calculate the ratios. They will know what each of the ratios means.

 

But, DCF requires one to have more than basic mathematic skills. You must first estimate the discounting rate. Also, it will involve discounting of some cash flows.

 

Both methods have their strengths and flaws. DCF is more effective than multiples in stock valuation. It does involve complicated calculations. But it is useful in dealing with risks and uncertainties.

 

Real-World Example of Using the Multiples Approach for SaaS Valuation

 

Let us assume that David wants to conduct this approach. He wants to compare where major banking stocks trade to their earnings.

 

He can do this by creating a watchlist of the S&P 500’s four most extensive banking stocks. These include each bank’s P/E ratio.

 

David can see that Citigroup Inc. trades at a discount to the other three banks to its earnings. It has the lowest P/E ratio of the group at 9.57.

 

He works out the P/E ratio mean, or average, of the four stocks. Then, he adds them together and divides them by four.

 

He finds a common thread between the three firms. These are Bank of America Corporation, Wells Fargo & Company, and Citigroup. They all trade at a discount to the primary bank P/E ratio using this approach.

 

Conclusion

 

Valuation multiples are the fastest way to check a firm’s value.  This can help your team understand many things. This includes:

 

• What is our business currently worth?

 

• How can adjustments be made to increase its value?

 

• What is a fair price for another business?

 

• How do current valuations relate to historical periods?

 

Investors expect a steep discount for the risk they are taking today. This is to achieve an attractive return tomorrow. These methods help ensure this.

 

How investors value a firm in the future creates a clear ‘valuation’ goal for your startup. After all, your precious firm created on your idea must have a proper valuation!