Valuation by Multiples

There are two common types of valuation using multiples:

Comparable transactions for privately owned companies. Using this method, the valuator first tries to find a number of comparable transactions (e.g. where companies of a similar nature were bought and sold). There are many indicators to which a business valuator can choose to value a business, including:

  • Gross revenues;
  • Net revenues;
  • Net profit before taxes; or
  • Net profit after taxes.
  • EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization);
  • EBIT (Earnings before Interest and Taxes);
  • SDCF (Shareholder Discretionary Cash Flow);

There are also asset-based methods of valuation. It requires knowledge of the company and the context, and good judgment, to choose the most appropriate indicators, based on which to conduct the valuation. Once the indicators are chosen, there is a significant research task to select the appropriate companies that are comparable. There is seldom a perfect fit in comparing the different lines of businesses that companies conduct, their size, geographic focus, etc. Once again, it boils down to judgment from experienced analysts.

For example, if one concluded from among a representative sample of indicators and transactions, that the average transaction for comparable companies was valued at a certain EBIT multiple, then this is the metric that could be used for valuing a company. Often it helps as well to have contact with investors who will share information as to what types of multiples they use.

Although the above may seem simple in theory, in practice there are numerous pitfalls. The information available is in summary form and never contains the detailed information that really sets the true value or price that a business sold for. Some of the additional information that needs to be taken into account:

How old are the comparable transactions? Market conditions may have changed since the time of the transactions.

Are the transactions truly comparable? Have truly similar or comparable companies been selected? Are the markets in which they operate truly comparable?

If EBITDA or EBIT of the company being valued contains distortions (e.g. where senior management are drawing dividends in lieu of salary), then these distortions will only be multiplied when applying a multiplier.

There may be certain “skeletons in the closet” which make the company being valued completely unsaleable, in which case any valuation is purely artificial.

Too often, people simply throw around multiples without exercising proper judgment. The fact that a multiplier is being applied means that it is also possible to multiply the extent of any error! What you put into a valuation, in terms of effort and expertise will correlate to the accuracy and degree to which you can rely on the valuation.

Publically Listed Company Comparables. Under this method, valuators look not at past transactions—but at current valuations of comparable publically listed companies, once again, typically as a multiple of their own EBITDA, EBIT or revenues, as at a particular point in time.

Once again, the above seems to be simple, but is not without pitfalls:

Are the comparable companies truly comparable?

Publically listed companies usually trade at higher multiples than smaller mid-sized private companies, as they are much more liquid, have better corporate governance, are more transparent, and usually have less risk. Hence, when valuing a private company, an appropriate discount must usually be applied to the multiple derived from public companies. Estimating the size of this discount is highly subjective and requires both experience and good judgment.

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