Relationship Between Revenue Multiple Expansion and EBITDA Margin and ROIC
1) What is a reasonable assumption of REVENUE exit multiple expansion based on growing EBITDA margins and ROIC?
Example: Purchase multiple of 20x and over the course of 5 years, the margins improved by 4x and ROIC by 8x.
2) When the revenue and not EBITDA multiple expansion are concerned, do we even care about the margins?
3) In general, how would you defend a multiple expansion?
1) if the company is already profitable why not ext via ev/ebidta? Imo revenue multiples mostly driven by revenue growth, not margins and ROIC. You would use revenue multiples to value fast growing, unprofitable companies. Your example is impossible to determine in a vacuum
2) you still need to add the discounted intermittent cash flows. If the company is losing money, it’s going to have to issue more shares / if it’s making money, it can buy back shares or issue dividends. Both of which affect your valuation more than just the exit value.
3) historical valuation, misunderstood business model turnaround, comps comparison: “companies with x% ebitsa margin typically trade at 30x ebitda which is what we’re projecting”
1) What if the company was not profitable at the time of the transaction, but becomes profitable over the holding period?
Fair point: revenue growth from 30 to 45%, 18% market growth in the next 5 years, no debt. The rest stays the same as above;
2) Sorry, I do not understand what you meant here;
3) "companies with x% ebitsa margin typically trade at 30x ebitda which is what we're projecting" - OK, but you are still talking about comps selected by industry, geography, size, right?
1). Fair point, I'd lean towards ev/sales exit and then benchmark it against EV/EBITDA or pe ratio to see if it's reasonable.
The numbers you are giving still mean nothing in a vacuum. 45% revenue growth used to demand 20x+ EV/Sales for a SaaS company, now much less so, and 45% revenue growth for a SaaS company and consumer company lead to very different multiples. You'd have to look at the industry and what other companies in similar verticals / sub verticals with similar margin profiles and growth are trading at, and then extrapolate that to how the multiple will be in a couple years (eg during COVID, everyone was assigning insanely high multiples because the prevailing sentiment was that rates would be low for the foreseeable future, decreasing the time value of money. We since know that that is false). Then, there are still other factors to consider, eg how good is management, how defensible is the moat, etc... Finding the right multiple is much more of an art than science which is where the investment opportunity arises.
2.
You can say that a company will grow top line at 40% CAGR for 3 years and then slap a multiple on it, but to get the share price, you need to divide by shares outstanding. If the company is unprofitable, they may have to do a share issuance to make sure they still have cash. This would increase your denominator and obviously, lower share price. To take this into account, you can either 1. model shares outstanding, which tends to be less scientific than 2. model the free cash flows, which represent the cash that could go to shareholders.
For example (assume 0 net debt), if I have a company that does $100 in revenue and then does $150 in three years and the revenue multiple is going to expand from 8x to 10x. my total return is not (150 * 10x sales) / (100 * 8x sales), it's [(150 * 10x sales + the dividends you received in the middle)/(shares outstanding at exit)] / [(100 * 8x sales)/(shares outstanding at entry)].
This is a lot to model, but it can be captured by the discounted intermittent cash flows. It's just a DCF but instead of using the gordon growth exit method, you are using an exit multiple method. You can use XIRR in excel to calculate IRR.
3. Yes. You could compare to comps along different points on the S curve.
Again, want to reiterate that finding the right multiple is much more of an art than science, and it is much less scientific than using the Gordon Growth Method, but it does not necessarily mean it's a worse method. This is where the opportunity in investing lies!
If anyone has any thoughts would love to hear!
Thanks for reply!
1) I was not aware that a multiple would mean a different thing depending on the industry.
Yes, I would not compare the multiple of a SaaS to a consumer staples as they exist in different cohorts. But, if I take comps based on similar geography, industry, and size - I should already be isolating the discount rate and cash flow, leaving only the cash flow growth rate to vary. Then, at least in theory, the higher growth rates would mean higher multiples.
Are you saying that 50% revenue growth for a SaaS may be a 20x multiple, but 50% for consumer staples will most likely be a different (potentially higher) multiple? Would this be mostly due to the different risk profile (understand WACC) of each?
2) Oh, I got what you mean. Yes, I create a DCF and use the multiples method to double-check my results from the Gordon growth method. I take the median 2-year forward revenue multiple from the comps and decrease it by 2,3x to reflect declining growth rates over time. Please let me know if this sounds about right.
Yes, valuation can get artsy it seems!
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