I don't conceptually understand the multiple method.
What does it mean to "assign a ratio such as EV/EBITDA from a comparable company to determine the terminal value". I think the wording is confusing me.
Can someone give me an example?
Lets say: A comparable company has a EV/EBITDA ration of 8X - then what?
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To answer your example scenario: If a company has an EV/EBITDA ratio of 8X, then it's enterprise value is estimated at 8X it's EBITDA. So if EBITDA is $10, then the implied enterprise value is $80.
Keep in mind that the multiple is to be meaningful only when compared with other companies and their multiples
This is going to sound ridiculous, but it'll cut through your confusion with the verbiage.
Turkey is $5/pound and chicken is $7/pound - you are trying to figure out what a pound of pork is worth and you think pork is similar to chicken and turkey, so you decide it's worth $6/pound, assigning the average per-pound multiple of comparable deli meats.
EV/EBITDA is essentially just doing the same thing with a stream of cash flows.
All these other comments give a good idea of the concept around why your using such a multiple and how it connects to the company your valuing.
If you're asking in terms of what to do when explaining or doing the DCF, after reading that excerpt you quoted from the technical guide (It confused me at first too), after obtaining the average multiple from your comparable companies that you would like to use for the terminal value of firm you are trying to value, you would multiply the final years free cash flow by that average multiple you calculated and that would be your terminal value.
So for example if the average EV/EBITDA is 8x you would multiply the last year by 8x?
If the final year FCF is 5 and the EV/EBITDA is 8x the terminal value would be 40?
You are using a EV/EBITDA ratio, so applying that multiple to FCF is incorrect. You would apply the 8x to the final year EBITDA.
By using comparable companies, you are looking at current valuations from companies engaging in similar lines of business. The rationale behind this being, by looking at the similar companies and finding an average/median valuation metric (EV/EBITDA) between them, you would be able to use that particular metric in order to value the business you are looking at. This could be based on the current and projected market valuations (public comps), or precedent transactions in the specific industry the company is in.
Now for the DCF there are two commonly used terminal value methods, perpetuity and the exit multiple method. Specifically, for the exit multiple method, you are implying that the company would be sold at the conclusion of your projection period. Thus, by using EV/EBITDA, for example, you are using the average/median ratio from similar companies to project the companies value if sold at the end of the projection period. As a result, you would multiply that companies' 2021P EBITDA by the derived EV/EBITDA projection (from the comps) in order to arrive at an implied terminal value, which you would then discount to the present value. Finally by adding this number back to the present value of the FCF you would arrive at the implied enterprise value of the company.
It is worthy noting that the exit multiple method is heavily used by private equity firms when valuing an invested company ("exiting" the company after ~ 5-8 years).
Perfect illustration guys
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