Article written by Farhan Fazli, CPA at SEGAL GCSE LLP, in the quarterly Canadian news roundup, a newsletter published by
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Effective July 1 – Valuation multiples are usually mentioned in the media in connection with public company share prices or M&A activity. These valuation measures appeal to private business owners, who can easily understand and apply them to estimate the value of their own companies. However, when making these comparisons, we need to consider the theory behind the use of valuation multiples, the assumptions underlying the different types of ratios and their relevance to the situation. Business owners must also consider certain restrictions when using public company ratios to value a small private business.
The theory underpinning evaluation multiples
The application of valuation multiples to similar businesses (commonly referred to as the comparable public company method, or comparable business analysis) is based on the premise that these businesses have similar underlying economic data, which is evident in their financial or operating measures.
In reality, there is never a perfectly comparable company. In fact, there are always certain differences. Size, product and service offering, geographical reach, cost structure and quality of management can all differ greatly. As a result, you need to be extremely cautious and carry out a rigorous analysis when adopting the multiple of another company more or less similar to your own.
Valuation multiples are in fact a simplified form of discounted cash flow. Mathematically, the multiple corresponds to the inverse of the capitalization rate, defined as “r – c”, where “r” represents the required rate of return and “c” the long-term growth rate. Thus, a valuation multiple is essentially a derivative of the perpetuity equation in the case of a sustainable business enjoying a constant growth rate. As a result, multiples can be of limited use when a business opportunity has a short lifespan, or when a company anticipates significant growth (or contraction) for a few years.
Types of multiples
Enterprise value multiples
Enterprise value, or EV, is the total value of a company, comprising all forms of capital, including interest-bearing debt and equity. The most common multiples used to derive Enterprise Value are based on revenue and EBITDA.
Income and EBITDA are both estimates of the cash flow available to all stakeholders (equity holders and debt holders alike), which corresponds to the definition of EV. EV multiples are widely used in valuations, as they are neutral to capital structure and can be applied to all companies, regardless of their subjective choices regarding finances and capital structure.
1) Sales multiples
Income capitalization is assumed to be achieved by deploying debt and equity in optimal proportions. With this in mind, an income multiple will always represent value for both debt and equity holders, such as EV. The income multiple is reported as EV/income.
Revenue multiples are not as relevant a measure of cash flow, since they do not include operating expenses, the subject’s cost structure, or comparable businesses. These multiples are therefore most useful when operating parameters are consistent across a sector (e.g. regulated industries). In addition, revenue multiples are often used by default, when profit or cash flow indicators are not available. It’s for this reason that EV-revenue is also often used as a default when valuing technology companies or fast-growing emerging businesses.
| Company | Income | EBITDA | VE | Multiple | |
| Amount in million | LTM | LTM | Current | EV/income | VE/BAIIA |
| Medical technology company | 68 | -25 | 223 | 3,3 | N/A |
| Apprenticeship program technology company | 134 | -15 | 1 444 | 10,7 | N/A |
| Enterprise SaaS | 623 | -164 | 2 616 | 4,2 | N/A |
2) EBITDA multiples
EBITDA multiples, like sales multiples, are a derivative of enterprise value, and that’s because EBITDA reflects earnings before interest, taxes, depreciation and amortization. An EBITDA multiple represents the neutral value in relation to the capital structure. The EBITDA multiple is referred to as EV/EBITDA.
The EV/EBITDA multiple is more often used for more mature, established businesses, with more sustainable EBITDA levels that reflect future earnings at steadier growth rates. The table below summarizes average EBITDA for various S&P 500 sectors as at May 8, 2022:
| Multiple EV/EBITDA by industry | |
| Industry sector | VE/BAIIA |
| Energy | 6,1x |
| Service providers | 10,8x |
| Material | 6,5x |
| Industrial | 10,2x |
| Consumer discretionary goods | 11,4x |
| Consumer staples | 12,4x |
| Health | 13,2x |
| Information Technology | 14,7x |
| Communication services | 8,9x |
*Source: CapitallQ
While not perfect, the above table shows a correlation between EBITDA multiple and industry growth, or growth prospects, with higher multiples in sectors with greater growth. In addition, there may be a negative correlation between the multiple and the amount of capital reinvestment required. Companies that are almost identical, with the same EBITDA, but with higher capital expenditure requirements generate less cash flow, which is not taken into account in the EBITDA calculations.
Operating income multiples
The price/earnings ratio (P/E) and the price/book ratio (P/B) are the multiples most commonly used to determine the market value of a company’s equity. In the case of the P/E multiple, both the numerator and denominator refer to the company’s equity, where the share price represents the price of a common share, and the residual earnings attributed to equity holders are calculated after servicing any interest associated with debt holders. In the case of the P/B multiple, the comparison is essentially between the market value of the company’s equity and its book value or historical value.
3) Net income multiple
P/E multiples, while a popular indicator of stock performance, are not very often used to value private companies or to price a transaction involving a private company. This is because the capital structure incorporated in the multiples of listed companies does not always correspond to that of private enterprise.
Furthermore, acquisitions of private companies are generally negotiated on an enterprise value (EV) basis, making the use of an EV-based valuation methodology, such as EV/EBITDA, more relevant in the context of mergers and acquisitions (M&A).
4) Multiples of book value
The P/B multiple is also a useful valuation metric, as it provides a direct comparison between the book value and the market value of a company’s equity. This multiple is most commonly used in sectors with significant tangible asset backing, and is calculated by dividing total market capitalization by the book value of shareholders’ equity.
The application of P/B multiples is often used in the valuation of financial institutions with large balance sheet loans and investments. Since the value of the loan portfolio on the balance sheet is directly linked to market-driven returns, the price/book multiples of comparable listed financial institutions with portfolios of similar credit ratings are considered appropriate indicators for valuing unlisted financial institutions. Moreover, using EBITDA multiples to value financial institutions would not be appropriate, as it is often difficult to separate interest income and expenses of an operational nature from those linked to the capital structure.
On the other hand, P/B multiples are less useful when a company’s underlying value is based on significant goodwill or intangible assets that are not always adequately reflected in its balance sheet.
The relevance of public company multiples
We must carefully assess whether public and private companies are comparable when attempting to apply public multiples to their private counterparts. In particular, the public comparator may deserve a higher multiple for many reasons, including the following:
- Larger size and greater economies of scale;
- Reduced risk thanks to a broader range of products and services, customer segments and geographic coverage;
- Easier access to capital;
- Better growth prospects;
- Greater liquidity associated with minority interests.
In addition, public company prices can fluctuate significantly due to investor sentiment linked to transitory economic, industrial and political events. As a result, the value of a public company at any given time may not reflect its true intrinsic value. What’s more, some companies are well-publicized, often in the public spotlight, and therefore attract significant investor interest. However, this interest is often not justified by recent financial results or reasonable future financial projections.
Conclusion
Sellers and buyers of private companies often price transactions based on EBITDA or sales multiples, due to their ease of application, as well as the fact that these multiples are generally calculated without debt, and that most transactions are structured without counting debt and cash. However, the use of a particular multiples methodology is not appropriate in all circumstances, and the choice of multiplier based on similar public companies, without adequate consideration of differences in size, operations and profitability, can lead to misleading conclusions.
Consequently, valuing private companies using market multiples is an exercise that needs to be undertaken with caution and diligence. This requires in-depth analysis to determine the relevance and application of listed company multiples to an open market transaction involving private companies.
Contact our dedicated business valuation team to find out more.
