What is Multiple Expansion?
Multiple expansion is a form of arbitrage that employs the purchase of a securityMarketable SecuritiesMarketable securities are unrestricted short-term financial instruments that are issued either for equity securities or for debt securities of a publicly listed company. The issuing company creates these instruments for the express purpose of raising funds to further finance business activities and expansion. at a lower valuation multipleTypes of Valuation MultiplesThere are many types of valuation multiples used in financial analysis. They can be categorized as equity multiples and enterprise value multiples. and selling a security at a higher valuation multiple. Generally, companies with lower valuation multiples are smaller and with higher investment risk compared to companies with higher valuation multiples.
In addition, the concept of “multiple expansion” can be used to describe any increase in the company’s valuation multiple.
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Multiple Expansion in Private Equity
Although multiple expansion can be related to any type of purchase, this concept is widely used in private equity dealsPrivate Equity Transaction TimelineThere are various steps involved in a Private Equity Transaction Timeline. The diagram below shows the different steps in an M&A transaction, which include signing an NDA, financial modeling and valuation, and generating a quality of earnings report.. It is utilized along with leverageLeverageLverage is a strategy that companies use to increase assets, cash flows, and returns, though it can also magnify losses. There are two main types of leverage and deal structure.
It is difficult to predict a company’s multiple expansion. However, private equity firms apply special techniques to achieve the following objectives:
- Increase the operational efficiency and cash flow generation during the life of the investment.
- Monitor the current valuation multiples and M&A activities in the market.
- Proactively seek the best exit time of the investment at the highest valuation multiple.
Example of Multiple Expansion
Private equity firm PE Partners has decided to acquire Startup Inc. PE Partners is willing to employ multiple expansion to profit from its investment in Startup Inc. Currently, Startup Inc. has an Enterprise ValueEnterprise Value (EV)Enterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest (EV) of $10 million and an EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of $5 million. PE Partners has determined that EV/EBITDA is the most appropriate valuation multiple for the multiple expansion indications. The initial EV/EBITDA multiple is 2x.
In order to achieve the expansion, PE Partners plans to drive the operational efficiency of Startup Inc. by boosting production and eliminating some costs.
After three years, the company’s EV reaches $100 million and EBITDA becomes $20 million. Thus, the company’s EV/EBITDA is 5x. In three years, Startup Inc.’s multiple has expanded by 2.5 times. PE Partners then decides to sell Startup Inc. to profit from its initial investment.
Additional Resources
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
- Business Valuation GlossaryBusiness Valuation GlossaryThis business valuation glossary covers the most important concepts to know in valuing a company. This guide is part of CFI's Business Valuation Modeling
- Comparable Company AnalysisComparable Company AnalysisThis guide shows you step-by-step how to build comparable company analysis ("Comps") and includes a free template and many examples.
- Precedent Transaction AnalysisPrecedent Transaction AnalysisPrecedent transaction analysis is a method of company valuation where past M&A transactions are used to value a comparable business today.
- Valuation MethodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions
