What are Valuation Multiples?
Valuation is often described as a ratio instead of the monetary amount since this allows valid comparison of different sized businesses. By convention, these ratios are most commonly expressed as a multiple rather than as a percentage (the real estate sector is a notable exception). The value is compared with a value driver to calculate the valuation multiple. For example, enterprise value of 1,000 divided by EBIT of 100 is expressed as a multiple of 10x. If a buyer pays 1,000 with the expectation of an earnings stream estimated at 100 per annum then they have paid 10x EBIT.
Key Learning Points
- Valuation multiples allow for comparison between similar companies (similar industries with similar operations)
- A valuation multiple is comprised of a value (EV) as the numerator and a value driver (EBITDA) as the denominator
- The numerator and denominator must be consistent to allow for reasonable comparison (i.e. both before or after the impact from capital)
- Multiples can vary depending on the company and even be industry-specific (Price/book, Revenue/Hotel rooms etc)
Understanding Valuation Multiples
As with all ratio calculations, it is important to compare like with like. For example, the valuation multiples for a mature sector such as supermarkets are likely to be very different from those of a high growth sector such as technology.
Enterprise value is compared with an operational value driver before any capital structure impact. In the context of the income statement, this means “before interest”. Equity value, on the other hand, should be compared with a driver post capital structure impacts since it is the residual value attributable to the shareholders. A simplified example follows:
Enterprise value is the value of the operational business and is unaffected by capital structure changes (except at high leverage levels where the level of debt confers extra risk as the default probability rises). This means that enterprise value and enterprise value multiples are independent of capital structure.
Equity value is the residual attributable to shareholders after the providers of debt capital are taken into account so equity multiples are impacted by leverage. This means that equity multiples are impacted by differing capital structures, whereas enterprise value multiples are independent of capital structure. Therefore, it is easier to draw conclusions about similar businesses using enterprise value multiples even if they have different capital structures.