Demystifying multiples

“What multiple are you currently using?”, “Is the multiple 5 or 6?” are questions that we are regularly asked. Unfortunately, it really is not that simple.

An earnings based valuation is designed to value a business based on the level of earnings that are likely to be maintainable in the future. A multiple is usually applied to those future earnings to arrive at the Enterprise Value of the business (the capitalised value of those earnings).

Whilst sometimes we do arrive at a multiple of 5 or 6, a huge amount of information needs to be taken into account before drawing that conclusion.

Is it right to value the business by reference to a multiple?

Firstly, the type of multiple needs to be determined and this requires consideration of the most appropriate measure of earnings. If the company is reasonably sophisticated and produces reliable and detailed cash flow forecasts, then a Discounted Cash Flow (DCF) method of valuation should be carried out. This valuation method uses a ‘discount rate’ rather than a multiple. By way of a crude explanation, a discount rate in many ways is a multiple flipped on its head, it effectively does the same job as a multiple. Discount rates and DCF valuations are totally separate topic for another highly technical article!

There are different types of multiple

Industry specific methods should also be thought about, as in practice some types of business are valued using a different valuation method entirely. An example of this are Software as a Service (SaaS) companies, which can be valued based on the recurring revenue multiplied by SaaS revenue multiple. Again, industry specific multiples and associated valuation methods are a whole separate article or even series of separate articles.

EV/EBITDA multiples

EBITDA (Earnings Before Interest Tax Depreciation and Amortisation) is a ‘clean’ measure of earnings. Clean because EBITDA effectively removes the effects of different capital structures, different tax rates (and tax reliefs) as well as removing the impact of different accounting policies relating to tangible and intangible fixed assets.  

EV/EBITDA multiples (Enterprise Value ÷ EBITDA) effectively replaced P/E Ratio (Price Earnings) multiples approximately 10 years ago. Whilst still a consideration for historical valuations P/E ratios have been phased out because they are based on pre or post tax profit, measures of earnings that are less ‘clean’ than EBITDA.

In this article we discuss some of the sources we review when estimating an EV/EBITDA multiple.
A multiple is the number of times EBITDA that a buyer is willing to pay. The overriding factor determining the multiple is risk and we need to ensure that the risk associated with that business being able to achieve that level of EBITDA is addressed in the multiple selected. 

Care should be taken to consider whether EBITDA is based on forecast or historical figures because the comparative EV/EBITDA multiples being sought should match.  

Relevant transactions

A good place to begin when attempting to locate appropriate multiples is to seek to find details of recent transactions involving similar companies to the company in question. The purpose of this is to see what multiples buyers actually paid when buying similar companies.

It is best practice to locate the multiple for transactions involving companies as similar as possible to the company being valued, in terms of:

• Industry/business activity;
• Size – the risk profile for small companies is different to large companies;
• Geographical location – the market sentiment in the US may for example be significantly different to the UK at a given time; and
• Type of transaction – it is important to ensure the comparative transaction in the database is for a full buyout if we are valuing 100% of the shares and not for a small tranche of shares.

We subscribe to a number of different subscription based platforms, each of which provide different information about deals due to differing methods of compiling the data. It is important to properly understand each information source and how the data is compiled and know how to use each platform including how to safely filter the databases.

Where there are no transactions

It is not always possible to locate enough appropriately similar transactions, so we also consider other more general multiple sources including reports of multiples for different industry sectors and non-industry specific indices.

These sources all have their pros and cons and it is important to be aware of these to be able to properly factor their results into the overall assessment of the multiple.

We also consider the multiples suggested by the share price of listed companies in the same industry as the company in question, although of course there are significant differences between listed companies and owner managed businesses (even large ones).

Bringing it back to the business being valued

In addition, we assess the key strengths, weaknesses, risks and opportunities facing the business being valued. Two businesses may at a particular point in time be equally profitable but have very different prospects as a result of specific external and internal factors affecting them. For example, a company which is heavily dependent on a single customer is more risky than a company with a very large customer base. This risk is addressed through adjustment to the multiple applied to maintainable EBITDA.

Summary

In short, our valuations are always undertaken in a hypothetical situation rather than an actual deal scenario, but we do invest a significant amount of time to arrive at a robust, balanced and appropriate multiple.

Ultimately the value of a company is what someone actually pays for it, and even then it could be argued that a buyer might have overpaid or underpaid. That topic alone could lead us into yet another LinkedIn article about value and the different definitions of ‘market value’, ‘equitable value’ and ‘fair value’…

Our Dispute, Investigations and Valuation team is regularly instructed by lawyers to undertake valuations for use in disputes, or by business owners, or their accountants, in non-contentious situations.

Read more here.