What is the logic behind using exit multiple for terminal value?

VanPro's picture
Rank: Senior Baboon | 198

For one of the interviews I had, the interviewer asked me the logic behind using exit multiples, I screwed up the answer cuz I have never really thought about why we could use an exit multiple to calc TV (Any input would be most appreciated).

I also have trouble understanding why it would even make sense to apply comp multiples, which are collected from the present time, to the subject company's EBITDA or revenue at a time so far into the future.

In addition, do we usually use LTM EBITDA or current EBITDA or future EBITDA for the exit multiple? How do we select exit multiple, by taking the average trading multiples of similar comps over the past years or....?

Thx a million guys!!!

Comments (4)

Best Response
Nov 19, 2016

I'd approach it from the perspective of the Gordon growth model. You'll recall GGM assumes once a company hits stable growth, then price = dividend/ (cost of equity - long term growth rate)

Conceptually, shift this back from equity valuation to firm valuation. EV = cash flow to to the firm / (k - g)

Treat EBITDA as a proxy for cash flow. Then you get EV = EBITDA/ (k-g)

Using simple equations to shift this around, EV/EBITDA = 1/(k-g) = an EBITDA valuation multiple.

Ergo, we use a valuation multiple for terminal value for the same reason we use the GGM for long term valuation on a business when it is in a stage of stable growth.

Then go back to your university notes on why we use GGM. Those are your reasons why you use multiple for TV.

Where is it not appropriate to use a multiple for TV? Where the GGM assumptions don't hold. Which is usually where the company is not yet in its long term, mature growth rate, or where the company is in decline.

EDIT: You can use this same logic to understand why multiples may be higher or lower for a company ie that should be a product of 1/(k-g).

    • 4
Nov 20, 2016

Hey SSits, your comment is very helpful. Another quick question, do bankers usually use EV/LTM EBITDA, or EV/current year EBITDA or EV/Projected EBITDA for exit multiple? Thx a lot!!!

Nov 19, 2016

Typically the first or the second, but on a pro forma basis. For example, if the company has signs up a 3 year contract in November, the pro forma LTM EBITDA will be adjusted by the amount of EBITDA that contract would have contributed if it had been in place for the LTM. Similarly, if the company had gone through an efficiency review in the last 6 months, spending $5m on consultants to cut $20m of costs out of SG&A, both the $5m and $20m will be added back to pro forma LTM EBITDA to reflect the business EBITDA generation capacity as it is now. You'll normally get a quality of earnings (QOE) report from a good accounting firm which signs off on the pro forma adjustments.

LTM EBITDA and current year EBITDA (if you're close enough to year end) is "real" EBITDA. Projected EBITDA is more speculative, less reliable.

In terms of how close you need to be to year end - a deal going into debt syndication now or in December would still be sold off LTM 30 September EBITDA.

    • 3
Nov 20, 2016