The Multiples: A Quick and Dirty Approach to Valuing a Company.
Knowing how to sell a company is a kind of art. Sometimes it's not just the passion that drives entrepreneurs and the purpose of venture capital funds, it's also the name of the game. The selling price on the one hand should reflect the value of the company at a given time and on the other hand produce conditions of mutual profit between the seller and the buyer and all the stakeholders involved.
Determining the value of a company is critical to all parties in a transaction. First of all, the owners of a company need to know the value of assets in order to decide whether or not to sell and at what price to negotiate when evaluating the sale of a subsidiary. Interested buyers must determine the company's value in order to set up bidding limits and strategy. In leverage buyouts, where debt levels are a significant part of the purchase price, creditors need to ensure operating cash flows and projected asset sales are sufficient to cover future debt obligations. In all these cases, the DCF method is a useful tool, but sometimes companies perform a valuation using multiples.
While multiples valuations are liked for their relatively simple and quick approach to estimating value, they must be seen as a final complementary check to a DCF method. With a multiples valuation, or relative valuation, you are able to estimate the value of a privately owned company based on the prices of comparable firms. A multiple is essentially a quotient, relating the market value or price to a key statistic, usually a measure of profitability. In multiples valuation, we start by creating a peer group, which is a list of comparable firms. Then the average or median multiple of this peer group and the profitability of the target company provides us with an estimate of our company's value.
A multiples valuation assumes that the observed price of a similar company or asset is a good estimate of the value of the target company. Whether a peer group is indeed comparable can be based on similarities of the risk profile, leverage, growth expectations, or size.
We generally distinguish between two classes of multiples: trading and transaction multiples. With trading multiples, you use prices for which comparable firms are traded in the market to estimate value. Transaction multiples use the prices paid for other comparable companies that were previously acquired as a proxy for value. Multiples can also differ but time period they are based on.
Historical multiples relate current values to historical results, trailing multiples relate current value to the past 12 months' results, and forward-looking multiples relate value to forecasts. The latter are often preferred over historical or trailing multiples, since you typically want to value a company based on what you expect going forward. Within each class of multiple, there are also different types of multiples.
Most common are earnings multiples, such price-to-earnings or enterprise value over EBITDA multiples, which relate the value of a company to a measure of its gross profitability. Especially the latter is a popular multiple, because it is relatively robust and less distorted by differences in accounting conventions or the leverage of the firm. Another type are sales multiples, for instance, price-to-sales. This type is often used for companies with negative earnings, such as startups and new ventures. Next, are market-to-book multiples. For example, market capitalization-to-book value of equity or alternatively market price-to-book value per share. A drawback of this type is that it doesn't take into account the actual returns that are made on the equity or assets, and it can be distorted by accounting conventions. Lastly, industry-specific multiples are used, which relate value to some industry-specific metric. For instance, social media companies, such as Twitter, provide completely new business models. For Twitter, Facebook, and other similar companies value is driven largely by the number of users and internal interactions. Therefore, a more informative way to determine the value Twitter creates is by looking at value per user account.
One of the main limitations of multiples valuation is that the method provides a relative measure of value based on prices and therefore you implicitly make the assumption that the price paid is equal to fundamental value and that markets are efficient. But that doesn't always have to be the case, as the excessive valuation of tech companies during the dot-com bubble of the early 2000's may have demonstrated. Furthermore, comparability is crucial, but finding a perfect twin is extremely difficult. In order to truly understand and trust comparability, we will need to look closer at the fundamentals behind the multiples. This will help us understand why multiples can differ across firms that are similar in size and which are active in the same industry.
To summarize this article: multiples valuation should be used as a complementary valuation method and be supported by other valuation approaches. A company valuation can be based on a combination of DCF and multiples. But the ultimate valuation judgment should also involve strategic aspects, such as: the strategy of the firm, the quality of management, the competitive position, and the industry attractiveness, or the speed of innovation.