Valuation multiples are financial measurement tools that evaluate one financial metric as a ratio of another, in order to make different companies more comparable. Multiples are the proportion of one financial metric (i.e. Share Price) to another financial metric (i.e. Earnings per Share). It is an easy way to compute a company’s value and compare it with other businesses. Let’s examine the various types of multiples used in business valuation.
Types of Valuation Multiples
There are two main types of valuation multiples:
Enterprise Value Multiples
There are two main methods of performing analysis using multiples:
Comparable Company Analysis (“Comps”)
Precedent Transaction Analysis (“Precedents”)
Advantages and Disadvantages of Valuation Multiples
Using multiples in valuation analysis helps analysts make sound estimates when valuing companies. This is especially true when multiples are used appropriately because they provide valuable information about a company’s financial status. Furthermore, multiples are relevant because they involve key statistics related to investment decisions. Finally, the simplicity of multiples makes them easy to use for most analysts.
However, this simplicity can also be considered a disadvantage because of the fact that it simplifies complex information into just a single value. This simplification can lead to misinterpretation and makes it challenging to break down the effects of various factors.
Next, multiples portrait a snapshot of a company’s status rather than its potential. As such, they do show how a company grows or progresses. Therefore, multiples reflect short-term rather than long-term values.
Price/Book Ratio – useful if assets primarily drive earnings; computed as the proportion of Share Price to Book Value Per Share
Dividend Yield – used for comparisons between cash returns and investment types; computed as the proportion of Dividend Per Share to Share Price
Price/Sales– used for firms that make losses; used for quick estimates; computed as the proportion of Share Price to Sales (Revenue) Per Share
However, a financial analyst must take into account that companies have varying levels of debt that ultimately influence equity multiples.
2. Enterprise Value (EV) Multiples
When an assessment is needed on a merger and acquisition, enterprise value multiples are the more appropriate multiples to use, as they eliminate the effect of debt financing. The list below shows some common enterprise value multiples used in valuation analyses.
EV/Revenue – slightly affected by differences in accounting; computed as the proportion of Enterprise Value to Sales or Revenue.
EV/EBITDAR – most used in industries in the hotel and transport sectors; computed as the proportion of Enterprise Value to Earnings before Interest, Tax, Depreciation & Amortization, and Rental Costs
EV/EBITDA – EBITDA can be used as a substitute of free cash flows; is the most used enterprise value multiple; computed as Enterprise Value / Earnings before Interest, Tax, Depreciation & Amortization
EV/Invested Capital – used for capital-intensive industries; computed as the proportion of Enterprise Value to Invested Capital
There are many more equity and enterprise value multiples used in company valuation, this article only presented the most common ones. A thorough understanding of each multiple and related concepts can help analysts better apply multiples in making financial analyses.
All of the above, are utilized within the two common approaches to valuation multiples:
Comparable Company Analysis – This method analyzes public companies that are similar to the company being valued. An analyst will gather share prices, market capitalization, capital structure, revenue, EBITDA, and earnings for each company. Learn more about performing comparable company analysis.
Precedent M&A Transactions – This method analyzes past mergers and acquisitions (M&A) for companies in the same industry, which can be used as a reference point for the company that is being valued. Learn all about performing precedent transaction analysis.