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!!

Authors: Michael Kakanis & Mark Steinhardt

24.1.2020

Welcome Brent & Lachlan

We are delighted to formally announce the addition of Brent Wall (Associate Director) and Lachlan O’Rourke (Analyst) to the InterFinancial team.  Brent has joined the team full time after working as a Consultant for IFL in 2019, and was instrumental in the recently announced National Veterinary Care transaction. Brent has over 20 years of experience in […]

Read more
22.1.2020

Sector Dashboards January 2020

Our monthly dashboards cover seven key sectors of focus, with each sector built up by several subsectors that cover similar companies based on; products, end markets, services, assets classes or other characteristics. The publications include all companies listed on the Australian Stock Exchange that are actively traded and covered by research analysts, and hence have […]

Read more
22.1.2020

M&A 101 – back to basics

Being a new year, we thought it would be timely to provide a refresher on some key M&A concepts. Of course, there are a long list of things that go into making a successful transaction, but the following are some of the most important tips from our team to consider before entering a transaction process. […]

Read more
17.12.2019

Sector Dashboards December 2019

Our monthly dashboards cover seven key sectors of focus, with each sector built up by several subsectors that cover similar companies based on; products, end markets, services, assets classes or other characteristics. The publications include all companies listed on the Australian Stock Exchange that are actively traded and covered by research analysts, and hence have […]

Read more
16.12.2019

IFL advises National Veterinary Care on sale to VetPartners

ASX-listed National Veterinary Care Ltd (NVL) has announced that it has entered into a binding Scheme Implementation Deed with VetPartners. VetPartners is set to acquire 100% of the issued share capital of NVL by way of scheme of arrangement (Scheme). Under the terms of the Scheme, NVL shareholders will be entitled to receive AUD 3.70 […]

Read more
26.11.2019

Sector Dashboards November 2019

Our monthly dashboards cover seven key sectors of focus, with each sector built up by several subsectors that cover similar companies based on; products, end markets, services, assets classes or other characteristics. The publications include all companies listed on the Australian Stock Exchange that are actively traded and covered by research analysts, and hence have […]

Read more
22.11.2019

What’s in a multiple?

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 […]

Read more
23.10.2019

Sector Dashboards October 2019

Our monthly dashboards cover seven key sectors of focus, with each sector built up by several subsectors that cover similar companies based on; products, end markets, services, assets classes or other characteristics. The publications include all companies listed on the Australian Stock Exchange that are actively traded and covered by research analysts, and hence have […]

Read more
22.10.2019

Clairfield partners gather in Birmingham

Clairfield held its partners meeting in Birmingham last week with best practice forums, workshops on the building products, technology, services, and healthcare sectors, as well as some expert views on Brexit. The highlight of the meeting was the reception held at the Birmingham City Council House, a beautiful historic building that serves as the seat […]

Read more
21.10.2019

European Chemicals & Plastics Report

Clairfield’s UK partners note that M&A activity in the chemical and plastics sector remained steady in 2018 and forecast a bump in activity in 2019, driven by smaller, specialist deals in a fragmented market. The Clairfield industrial team is led by Chris Gregory. Read the full report here: 2019H1 European Chemicals and Plastics

Read more