What is a multiple?
Have you ever wondered what stock traders mean in the movies when they say “what’s it trading at?” Are you a tad confused when you hear “it’s worth about 4-times EBITDA”? If you are, you are not alone, and the truth is that the answer is not as complicated as one may think.
In its simplest form, a valuation multiple is a way of expressing the forward-looking value of a company based on a key financial metric derived from past results. As such, when a company is highlighted as being worth “4-times (4x) EBITDA”, it simply means that the fair market value of a company with EBITDA of $500,000 is about $2 million.
Depending on the company or industry, different valuation metrics may be favoured to express the value of a company. Some of the most popular valuation metrics are:
- EBITDA: This is Earnings before Interest Taxes and Depreciation/A It is seen as a reliable substitute to calculating a company’s cash flows from its operations, and before the costs of debt or taxes, which can vary depending on how a company is financed, and its tax jurisdiction. Furthermore, it is relatively easy to calculate based on a company’s financial statements.
- Seller’s Discretionary Earnings: This is typically calculated from EBITDA, with an add-back for owner’s compensation. It is meant to assess the amount of earnings that the company has access to use “with discretion”, and is typically meant for smaller, “owner-managed” companies.
- Net Pre-Tax Earnings: This method can be used for companies whose depreciation or amortization is similar to its annual level of spending on capital assets.
- Sales (or Revenue): This is rather self-explanatory, but one should note that this usually represents net sales, or sales net of commonly associated discounts, where applicable. This metric is usually reserved for high margin companies, that are highly scalable (i.e. ecommerce/tech), although it typically functions as a “rule of thumb” to assess the reasonability of a valuation approach based on cash flows (Note: more on this later).
How is the multiple determined for public vs. private companies?
For a public company, determining the multiple is usually a matter of performing some relatively simple math. Consider a company’s market capitalization (the price to purchase all of its outstanding shares) as its current market value. Dividing the market capitalization by a company’s sales or EBITDA, you will calculate the implied multiples.
This process is a little more difficult with a private company, because there is little or no publicly available information to derive the value, sales, EBITDA, or any other key metrics. This is often why Chartered Business Valuators are engaged by our clients. For a company that is successful enough to justify an income-based valuation approach – think of those that consistently generate revenue, income, and positive cash flows – a valuator will be provided with the confidential information to determine the most applicable metric and multiple to calculate value.
How is a multiple calculated?
The calculation of a valuation multiple involves the determination of a capitalization rate, which is used to convert a stream of cash flows into value. A “cap rate” factors in the risk associated with an investment, as well as expected growth. Generally, an investor would pay more for a less risky investment.
The most-commonly used method for calculating a cap rate for a private company is the “build-up” approach. This involves calculating a company’s WACC (Weighted Average Cost of Capital), which is a blended rate that equity holders (owners) and debt holders (lenders) would expect to earn from investing in or lending to a company. Debt typically requires a lower rate of return as compared to equity. From a company’s perspective, these expected rates of return are effectively the costs of obtaining equity or debt financing.
The cost of debt is usually derived from the market rate of available financing (i.e. the interest rate a financial institution would charge to lend money). It is calculated net of the applicable tax rate, since interest costs are tax-deductible.
The cost of equity considers various risk factors, including the risk free rate (i.e. government bonds), the equity risk premium (to provide additional compensation for holding equity over risk-free debt), as well as adjustments for the risk associated with size (bigger = less risky), industry, and company-specific factors.
These are added together after consideration for the relative market weight for each, because different companies may require alternative composition of equity or debt financing.
The chart below summarizes the key elements of the WACC:
The WACC is adjusted for an expected rate of growth that is usually linked to expected inflation, in order to calculate the capitalization rate (i.e. 20%). The inverse of the cap rate is the multiple. So, a 20% discount rate equates to a 5x multiple (1/20%).
How does the multiple calculation lead to value?
Once the multiple has been calculated, as noted above, it can be applied to the applicable stream of cash flows, which is most commonly represented by EBITDA, with normalizing adjustments. When valuators mention the word “normalizing”, it is just another way of noting that expected cash flows should be adjusted for items that are unusual or non-recurring. Consider if a company received an insurance settlement in a given year that considerably altered its EBITDA versus other years where no settlement was received. This, and other items, would be adjusted in calculating normalized EBITDA.
As noted earlier, if normalized EBITDA is $500,000, a 5x multiple would imply a value of $2.5 million. If the same company had normalized sales of $2 million, this would imply a sales multiple of 1.25x.
Is the multiple reasonable?
Valuators commonly rely on secondary or tertiary sources to assess the reasonability of valuation multiples. This can include reviewing implied multiples from past public or private company sale transactions, public company implied multiples, or reviewing industry rules of thumb, which can include generally accepted starting points for value (i.e. 1x sales or 2x EBITDA, plus inventory). These help a valuator to ensure the multiple is a realistic representation of the market dynamics.
We would like to highlight that this is a fairly uncomplicated example, in order to articulate the basic understanding of what a multiple is, how multiples are calculated, and how they ultimately translate to valuation calculations. For ease of presentation, we have not discussed the additional considerations involved in a valuation. There are many components that go into a business valuation, and we recommend that you reach out to a Chartered Business Valuator if you are contemplating the need for one. As always, we encourage you to reach out to us with questions.