What’s in a multiple?22.11.2019
Every month we get questions about the earnings multiples we publish in our Sector Dashboards. People want to know which sector their business fits in, how they compare to the benchmark, and taking a step back – what do the multiples even mean?? Accordingly, this month we thought it would be worth giving a brief refresher course on what goes in to a multiple.
At the most fundamental level, valuing a business or asset is a function of two variables – the expected cash flows, and the certainty or risk associated with achieving those cash flows. The purest method of determining this value is using a Discounted Cash Flow (DCF) calculation – forecasting the cash flows into perpetuity, and discounting using a cost of capital to get to a present day valuation.
However, the DCF method requires a crystal ball, and a perfect assessment of the cost of capital. In the real world, investors tend to use earnings multiples as a proxy to a DCF. Crudely, an earnings multiple is the inverse of the discount rate used in a DCF. For example, a 25% discount rate roughly equates to a 4x multiple. The less risky the cash flows, the higher the multiple, and vice versa.
So, time for some definitions:
- Enterprise Value (EV) vs Equity Value (sometimes referred to as Price, or “P”). The easiest way to think about this is selling a house – the Enterprise Value is the price that the buyer pays, the Equity Value is the cash the owner gets after paying off the mortgage (any debt owing against the house, and in the case of a business, any excess cash or other assets in the business that aren’t used in producing the earnings);
- EBITDA. Earnings Before Interest, Tax, Depreciation and Amortisation. This is typically used as a proxy for cash flow, and to normalise for companies that have different depreciation policies and tax structures;
- EBIT. Earnings Before Interest and Tax. Similar to EBIT, but typically used as a proxy for cash flow for capital intensive businesses, where significant capital expenditure is required to maintain the earnings level;
- EV/EBITDA. Probably the most common valuation methodology, this roughly translates to the payback period (how many years until the investor gets their investment back);
- EV/EBIT. Like EV/EBITDA, but used more commonly for capital intensive businesses;
- EV/Revenue. Some early stage businesses, particular those in the IT sector, require substantial investment in the early stages before a sustainable profit level is achieved. For these businesses, revenue is often used in place of earnings, with the expectation being that once the business is scaled, profits will result. Revenue also has the benefit of being harder to manipulate than earnings;
- P/E. More commonly used for listed companies than in M&A transactions, this the Equity Value (otherwise known as Market Capitalisation) divided by the Net Profit After Tax (NPAT);
- PEG Ratio. The king of all ratios? This is the P/E ratio divided by the growth in Earnings Per Share (EPS), typically averaged over the forecast two year period. This ratio is commonly used as a measure of whether a stock is over- or under-valued.
Now that you know what all the acronyms mean, where do you find these benchmarks? The starting point is listed companies (which have the advantage of being updated regularly, but the disadvantage of being limited to a relatively small sample size), and M&A transactions (which have the advantage of a broader sample size, but with less reliable and dated information). There are also a few things you need to keep in mind when comparing your business to the benchmarks:
- Every company is unique – it is hard to find a large group of direct comparables for your business, so any comparison will not be perfect;
- You are limited to publicly available information. Acquirers have quite a bit of discretion around the information they disclose (if any), for example, is the multiple based on the historic or forecast period, are transaction costs and synergies included, have any normalisations been applied?
- You need to be aware of appropriate discounts and premiums. The most common of these are:
- Size: Larger companies are perceived as more diversified and therefore less risky, so attract a premium;
- Liquidity: Investments that can be easily converted into cash attract a premium (typically ~30%);
- Control: Investors pay more for control of the business (typically 20-40%);
- Listed company multiples are reported on a minority basis (without control) but include a liquidity premium, whereas transaction multiples typically include a discount for liquidity and a premium for control (clear as mud right?!!!);
- You need to compare apples with apples. It’s not uncommon for sellers to casually mention a multiple on one basis (eg. EV/EBIT) and for another business to pick this up and apply it to a different basis (eg. EV/EBITDA);
At the end of the day, earnings multiples are just a shortcut for analysing the riskiness of the cash flows of the business. Explicitly or implicitly, investors will seek to understand how the investment in question compares to its peers (what are the growth prospects, quality of management, customer concentration etc), and apply a multiple commensurate to the riskiness of cash flows.
Of course, every company and deal is unique, but multiples can be a helpful and simple way of benchmarking the value of your business. It’s important to know what goes into a multiple – and be sure to compare apples with apples!!