Types of Valuation Multiples

The idea behind valuation multiples is to get a multiple or a percentage that can be used on a comparable basis to relatively value the firm within its industry or with its peers. 

It is merely a statement of an asset's market value about a significant statistic expected to have some bearing on that value.

The multiples approach is predicated on the idea that similar assets trade at comparable values. It assumes that metrics like operating margins and cash flows used to evaluate businesses are comparable.

This is typically done by referring to a financial ratio as the earnings multiple, such as the price-to-earnings ratio (P/E). Usually, multiples rather than percentages are used to indicate these ratios.

There are numerous such metrics that firms can use in this analysis, and it is not advised to use a single metric to value and analyze the whole business.

Some are appropriate for a specific sector of the economy or a certain kind of business. The value of a company can be inferred by calculating several of these ratios.

These are best used comparably within the industry and the peer group. An advantage of relative valuation is that it is calculated easily compared to absolute valuation and gives us a broader comparable data set.

The valuation multiple is a significant financial metric for investors because it can estimate a company's value and compare it to its competitors.

What are the various forms of valuation multiples?

Different valuation multiples exist because there are many approaches to determining worth. For example, suppose the stock is traded publicly. In that case, you might multiply the current price per share by the total number of outstanding shares to get an idea of the company's market valuation.

The two groups into which valuation multiples typically fall are enterprise value (EV) and equity multiples.

Equity multiples also referred to as market multiples, essentially assess the company's performance by comparing the share price to a fundamental metric like earnings, sales, or book value.

Examples of equity multiples include price-to-earnings ratios (P/E), price-earnings-to-growth ratios (PEG), and price-to-sales ratios (P/S). 

Enterprise value is the value of the operational business. It includes the enterprise-value-to-sales ratio (EV/sales), EV/EBIT, and EV/EBITDA. 

Indeed, enterprise value multiples are sometimes regarded as better valuation models than equity multiples since they include capital structures.

Moreover, accounting variations have a minor impact on enterprise valuation multiples. This is due to the denominator's calculation being performed earlier on the income statement.

On the other hand, equity multiples might be unintentionally altered even if there are no changes to enterprise value. However, investors prefer equity multiples since they are simpler to compute and the information is easily accessible online.

Equity multiples

Equity price multiples are most relevant when investors acquire minority stakes in corporations. When comparing companies with very different capital structures, it is essential to be careful.

Due to the debt's gearing effect, different debt levels will impact equity multiples. Additionally, balance sheet risk will not be expressly accounted for in equity multiples.

1. P/E Ratio
   The price-to-earnings ratio, or P/E ratio, is determined by dividing the most recent reported earnings per share by the price of the shares currently outstanding (EPS).
   Due to data availability, it is one of the most often employed equity multiples.
2. Price/Book Ratio
   The price-to-book ratio, often known as the P/B ratio, is a financial metric that contrasts the share price of the current market with the book value of the company's assets. When assets are used to make earnings, accountants frequently use this ratio.
3. Price/Sales Ratio
   The price-to-sales ratio compares the stock's current price to its sales (revenue) per share. The calculation is:The price-to-sales ratio, or P/S ratio, is a financial measure used to determine the value of a company based on how much investors are ready to pay for each dollar of sales.

Enterprise Value Multiples

Enterprise value-based multiples are significant in mergers and acquisitions where the entire stock and liabilities of the target company are purchased.

Enterprise value = Market Cap + Debt - Cash

A few multiples, such as EV/EBITDA, are also helpful additions to minority interest valuations, particularly when the P/E ratio is challenging to comprehend due to significant variances in capital structures, accounting principles, or situations when net earnings are low or negative.

1. EV/Revenue

Enterprise value is divided by annual revenue or sales in the EV/Revenue valuation technique. This multiple is frequently applied to high-growth or early-stage companies that do not yet have profitable operations.

The Enterprise Value to Revenue Multiple is a valuation statistic that divides a company's corporate value-consisting of stock plus debt minus cash-by its yearly revenue.

Investors use EV/R and other fundamental indicators to determine if a stock is reasonably priced. Therefore, the acquirer shall use the EV/R multiple to determine an appropriate fair value.

2. EV/EBITDA

A valuation indicator used to analyze the financial health of businesses in the same industry or sector is EV/EBITDA. Since EBITDA excludes the cost of debt, it is used in place of the P/E ratio.

The ratio is applied to determine if the company's worth is inflated or understated. Additionally, it aids in a better understanding of the risk and financial status of the company by the investors.

3. EV/Invested Capital

Invested Capital is the Total Capital (Total Debt + Total Equity), and EV is the Enterprise Value. Therefore, enterprise value (EV)/invested Capital is determined by dividing EV by Invested Capital. 

This ratio tells us how much Capital is invested into the business compared to its enterprise value. A higher number will mean the business is capital-intensive.

Components

As a ratio, it has two parts: a numerator and a denominator.

There is a valuation metric in the numerator. It can either be enterprise or equity value. The price-to-earnings (PE) ratio, the simple ratio of the company's earnings per share (EPS) to its share price, is the most well-known multiple of all and illustrates this.

A financial metric makes up the denominator. These statistics include income, EBITDA, EBIT, and others. The represented group in the numerator and denominator must coincide with any ratio calculation.

In addition, developing a thorough understanding of the business and its industry is essential to make an informed choice. For instance, a mature industry like construction will probably have different valuation multiples than a high-growth industry like technology.

Industry-specific operating metrics and multiples are also employed in some circumstances. For example, daily Active Users (DAUs), rather than the company's earnings, would be a better indicator of social media companies' valuation.

And because rental costs are added back to EBITDA in the transportation sector, EV/EBITDAR is frequently used. In addition, since it is the only option that makes sense in the case of unprofitable companies (e.g., EBIT could be harmful to such companies), the EV/Revenue multiple is frequently used.

How to Compare Companies Using Valuation Multiples

Investors use the multiples approach to assess a company's value and identify worthwhile investments.

Investors begin by locating comparable businesses and determining their market value. Then, using a crucial statistic such as the mean or median, a multiple is calculated for each comparable company and combined into a familiar figure.

The corresponding value of the company under analysis is multiplied by a value determined to be the integral multiple among the various companies to estimate the firm's value. 

Simply put, investors look for undervalued and overvalued companies compared to their intrinsic value using multiples.

The following considerations should be made when comparing businesses using valuation multiples:

• Make sure that you multiply across all of the companies. You will not be able to draw any reasonable conclusions if one company's analysis uses forward-looking projections and the other uses historical data.
• Similarly, confirm that both valuation multiples use EBITDA to measure earnings if one does. Finally, utilize various multiples to assess businesses whenever possible.
• The standard formulas that were previously described aim at various business principles. Multiple comparisons are helpful if the companies are comparable-for instance, if they are in the same industry.
• If your business is looking for funding, ensure you understand your value. For example, you can explain how you arrived at it, how well you performed compared to previous projections, and why your future revenue projections are reliable.

Advantages and Disadvantages

Using multiples for valuations can be profitably safe but occasionally unfairly conservative, so it has both advantages and disadvantages. Likewise, the ease of using multiples in valuation has both benefits and drawbacks.

1. Advantages 

The main benefits of multiples include their ease of use, the fact that they are based on actual market transactions, and the fact that they can give a reliable ballpark estimate of value.

Value judgments can be made using multiples because valuation is all about judgment. Moreover, multiples are reliable tools that, when used correctly, can reveal necessary information about relative value.

Multiples are essential because they include vital statistics that influence investment decisions.

2. Disadvantages

This valuation metric has a significant drawback because no future forecasts are considered when calculating multiples.

Only historical data, such as MRFY (most recent fiscal year), MRQ (most recent quarter), or TTM (trading twelve months), is used when comparing business fundamentals.

Comparing businesses or assets can become challenging when using multiple analyses. This is due to the possibility of different accounting policies among businesses, even if they appear to have the same business operations.

The dynamic and ever-changing nature of business and competition is not adequately captured by a multiple, which only provides a snapshot of where a firm is at a given moment.

Applying Valuation Multiple to Decisions

A valuation multiple is a ratio that illustrates the value of a business to a specific financial metric. It is a ratio, in essence, that is determined by dividing an asset's market value or estimated value by a particular line item on the financial statements.

Since a fundamental valuation analysis does not compare one company to another, you must calculate a given multiple for several comparable businesses and then determine the median or mean value for all those businesses to estimate the valuation.

Then contrast that value with the identical multiple for the given business.

Public companies in most industries publish financial metrics like the PE ratio. The metric can occasionally be one number from a financial statement, such as revenue or EBITDA, or it can also be a calculated number, such as a growth rate.

Whatever the case, once you have a metric for a company that interests you, you can research benchmark ratios of that metric to company valuations for that industry and multiply the ratio times the metric to get an estimated value for the company.

The valuation of a small or midsize private company can be approximated by multiplying one or more of its metrics by the relevant publicly available benchmark ratio.

Researched and authored by Shriya Chapagain | LinkedIn

Reviewed and Edited by Aditya Salunke | LinkedIn

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