Valuation multiples: definition, types and key methods
Those who analyze business performance can determine the value of a company and its assets using a variety of strategies, including valuation multiples. This method allows you to evaluate one metric as the ratio of another, which allows you to easily compare data from multiple companies. Learning more about this performance analysis method can help you develop the skills to succeed in a data-driven role. In this article, we define multiples in valuation and describe some of their key types, plus we offer methods on how to use valuation multiples and examine some of their advantages and disadvantages. – Valuation multiples are ratios that describe several financial factors of a company, providing clear and easily comparable data. – You can choose either stock or enterprise value multiples and use them with key methods such as comparable company analysis or precedent M&A transactions. – As valuation multiples can often be simple and clear, they can easily help promote information and data sharing. They can be overly simplistic, so analyze many different multiples and make sure to choose the right one for your company’s needs.
What are valuation multiples?
In finance, valuation multiples are tools you can use to calculate the value of a company by comparing several financial factors, often in the form of ratios. Multiples use relative statistics such as earnings, price per share, value per share, sales, and EBITDA (earnings before interest, taxes, depreciation, and amortization) to determine market value. A common example of multiples is calculating miles per gallon in a car because this number compares several factors using a ratio. Financial advisors, analysts, stockbrokers and investment banks may use valuation multiples when determining the value of a company. They can also use it if they want to buy shares, invest or propose mergers. Companies can hire consultants to calculate multiples and set a plan to achieve their financial goals.
Types of multiples in valuation
Here are the two main types of valuation multiples that you can use in business:
Equity multiples
Equity is a multiple method that examines particular elements of a company, such as a share price or profit. Equity multiples are most often used when investors own fewer shares in companies or are looking to acquire a smaller amount. Some examples of this include: – P/E ratio: This ratio compares price per share to earnings per share. This is the most common equity multiple due to data availability. – Price to book ratio: This compares the share price to the book value per share. You can use this ratio when valuing companies with many assets, like financial institutions. – Price-to-cash earnings: This compares the share price to cash earnings and includes other factors like depreciation and amortization. You can include other measures alongside this if there are material differences in accounting. – Dividend yield: This is the ratio of the dividend price to the share price. Mature companies that pay dividends to their shareholders use this to attract investors. – Price/Sales: This is the share price compared to the earnings per share. Unlike some others, you can easily calculate this ratio even if the company is making losses. – PEG ratio (price/earnings to growth ratio): This compares the share price to the expected growth rate and is common for high growth companies. You can use this if you have reliable growth forecasts.
Multiples for enterprise value
Enterprise value uses the value of the company in relation to sales. Enterprise multiples are common in mergers and acquisitions when the liabilities of certain companies can affect the market value. Here are some brief descriptions of common enterprise multiples: – EV/Sales: This is the calculation of enterprise value versus sales or revenue. The higher the ratio, the more expensive it is to invest. – EV/EBITDAR: This ratio compares enterprise value to earnings before interest, taxes, depreciation, amortization and rental expenses (EBITDAR). Investors in the hotel, retail or rental market usually calculate this to account for companies that don’t own assets but can rent. – EV/EBITDA: This compares enterprise value to earnings before interest, taxes, depreciation and amortization. This is one of the most common EV multiples, as it takes into account a company’s debt, cash, and profitability. – EV/invested capital: This ratio is most useful in capital-intensive industries with many business assets. This number can be competitive, as investments in similar assets can be common. – EV/NOPLAT: This is the ratio of enterprise value to operating profit after adjusted taxes. NOPLAT stands for adjustments such as tax efficiency so it can be subjective but if you calculate it equally across multiple businesses it can give an accurate valuation. – EV/enterprise FCF: This compares enterprise value to free cash flow. With this metric, you may find fewer differences in accounting between companies and this responds better to differences with many assets. – EV/OpFCF: This ratio compares enterprise value to operating free cash flow. This may include more estimates than EV/enterprise FCF so it may be more subjective but it shares similar benefits. – EV/capacity metric: Depending on the industry, the capacity metric may be production, subscribers or audience. You can calculate this even if figures are negative or volatile because accounting figures can be comparable between companies, so you can easily compare them.
Valuation multiples methods
Some of the most common methods of using these multiples are:
Comparable company analysis
Comparable company analysis (CCA) is a method that compares companies of similar size within an industry. Typically, analysts gather data such as stock price, free cash flow, cash earnings, and dividends to calculate various multiples. This allows investors to review similar data and determine company value. In some industries, analysts may establish a baseline across multiple valuations to determine whether investors are overvaluing or undervaluing a company.
Precedent M&A transactions
This method examines a company’s past mergers and acquisitions to determine possible investments. This gives analysts and investors an estimate of what a company could be worth should a new acquisition occur. Analysts can look at trends in similar companies within an industry if a company has not previously merged. This can challenge investors to examine all the market conditions when previous mergers and acquisitions took place and consider what might occur.
Benefits and challenges of valuation multiples
One of the main advantages of using multiples when valuing businesses is that they are clear and easy-to-understand measures of a company’s financial well-being. You can take common metrics, such as sales or cash income, and convert them into relative value. In addition, analysts and investors in many industries can use the multiples approach when valuing companies. This can help you effectively communicate across fields and areas using clear multiples. One challenge in valuation is that while companies may seem similar in size and industry, they may have different accounting policies that can skew the numbers. Similarly, calculating multiples can be simplistic, without taking into account adjustments or other factors that may affect the market. When one approach produces simplistic and static figures, review trends and a variety of approaches and use the comparative approach to make sure your conclusions are valid. By using and analyzing many different multiples, you can get a holistic picture of a company’s performance and financial health.
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