# Valuation Multiples

Understand the Concept of Valuation Multiples

• What is the role of valuation multiples in corporate finance?
• Why must valuation multiples be used when making comparisons?
• Which metrics go on the numerator and denominator of a multiple?
• How do you determine which valuation metric and financial metric to use?

## Valuation Multiples Definition

The basis of relative valuation (or “comps”) is to approximate the value of an asset (i.e. the company) by looking at how similar, comparable companies are valued by the market.

The median or mean of the industry peer group serves as a useful point of reference to determine the worth of the target company.

A valuation using comps has the distinct advantage of reflecting “reality” since the value is based on actual, readily observable trading prices.

However, the absolute value of companies – such as equity value or enterprise value – cannot be compared on their own.

A simple analogy is comparing the prices of houses – the absolute prices of the houses themselves provide minimal insights due to size differences between houses and other various factors.

Therefore, standardization of the valuation of companies is required to facilitate meaningful comparisons that are actually practical.

## Valuation Multiple Components

A valuation multiple is comprised of two components:

• Numerator: Value Measure (Enterprise Value or Equity Value)
• Denominator: Value Driver – i.e. Financial or Operating Metric (EBITDA, EBIT, Revenue, etc.)

The numerator is going to be a measure of value such as equity value or enterprise value, whereas the denominator will be a financial (or operating) metric.

Valuation Multiple = Value Measure ÷ Value Driver

A mandatory rule is that the represented investor group in the numerator and the denominator must match.

Note that for any valuation multiple to be meaningful, a contextual understanding of the target company and its sector must be well-understood (e.g. fundamental drivers, competitive landscape, industry trends).

Hence, operating metrics that are specific to an industry can also be used. For example, the number of daily active users (DAUs) could be used for an internet company, as the metric could depict the value of a company better than a standard profitability metric.

###### Numerator/Denominator Mismatches

For a valuation multiple to be practical, the represented capital provider (e.g. equity shareholder, debt lender) must match in the numerator and denominator.

If the numerator is enterprise value (TEV), metrics such as EBIT, EBITDA, revenue, and unlevered free cash flow (FCFF) could be used as the denominator since all of these metrics are unlevered (i.e. pre-debt). Thus, these metrics coincide with enterprise value, which is the valuation of a company independent of the capital structure.

Conversely, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and earning per share (EPS) can be used since these are all levered (i.e. post-debt) metrics.

## Examples of Valuation Multiples

In the chart below, some commonly used valuation multiples are listed:

 Enterprise Value Multiples (TEV) Equity Value Multiples

Note that the denominator in these valuation multiples is what standardizes the absolute valuation (enterprise value or equity value). Similarly, homes are often expressed in terms of sq. footage, which helps standardize value for differently sized homes.

Based on the circumstances at hand, industry-specific multiples can oftentimes be used as well. For example, EV/EBITDAR is frequently seen in the transportation industry (i.e. rental costs are added back to EBITDA) while EV/(EBITDA – Capex) is often used for industrials and other capital-intensive industries like manufacturing.

In practice, the EV/EBITDA multiple is the most commonly used, followed by EV/EBIT, especially in the context of M&A.

The P/E ratio is typically used by retail investors, while P/B ratios are used far less often and normally only seen when valuing financial institutions (i.e. banks).

When it comes to unprofitable companies, the EV/Revenue multiple is often used, as it’s sometimes the only meaningful option (e.g. EBIT could be negative, making the multiple meaningless).

## Trailing vs Forward Multiples

Often, you’ll come across comps sets with forward multiples. For example, “12.0x NTM EBITDA”, which simply means the company is valued at 12.0x its projected EBITDA in the next twelve months.

Using historical (LTM) profits have the advantage of being actual, proven results.

This is important because EBITDA, EBIT, and EPS forecasts are subjective and especially problematic for smaller public firms, whose guidance is less reliable and harder to obtain.

That said, LTM suffers from the problem that historical results are often distorted by non-recurring expenses and income, misrepresenting the company’s future, recurring operating performance.

When using LTM results, non-recurring items must be excluded to get a “clean” multiple. In addition, companies are often acquired based on their future potential, making forward multiples more relevant.

Therefore, rather than picking one, both LTM and forward multiples are often presented side-by-side.

Comparable Companies Analysis Output Sheet (Source: WSP Trading Comps Course)

## Valuation Multiples Excel Template

Now, let’s go through a training exercise calculating various valuation multiples.

To get started, fill out the form below for access to the Excel file.

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## Financial Data Assumptions

To start, we have three different companies with the following financial data:

• Company A: \$10.00 Share Price and 500mm Diluted Shares Outstanding
• Company B: \$15.00 Share Price and 450mm Diluted Shares Outstanding
• Company C: \$20.00 Share Price and 400mm Diluted Shares Outstanding

Since the equity market – otherwise known as the market capitalization – is equal to the share price multiplied by the total diluted share count, we can calculate the market cap for each.

From Company A to C, the market caps are \$5bn, \$6.75bn, and \$8bn, respectively.

Next, we’ll add the net debt assumptions to the equity values of each company to compute the enterprise value.

• Company A Enterprise Value: \$5bn + \$100mm = \$5.1bn
• Company B Enterprise Value: \$6.75bn + \$350mm = \$7.1bn
• Company C Enterprise Value: \$8bn + \$600mm = \$8.6bn

Here, we’re just using the simplistic assumption that larger companies hold more debt on their balance sheet.

## Valuation Multiple Calculation Example

Now, the valuation portion of our exercise (i.e. the numerator) is finished and the remaining step is to calculate the financial metrics (i.e. the denominator), which have been posted below:

We now have all the necessary inputs to calculate the valuation multiples.

### Valuation Multiples Formulas

The following formulas were used to compute the valuation multiples:

• EV/Revenue = Enterprise Value ÷ LTM Revenue
• EV/EBIT = Enterprise Value ÷ LTM EBIT
• EV/EBITDA = Enterprise Value ÷ LTM EBITDA
• P/E Ratio = Equity Value ÷ Net Income
• PEG Ratio = P/E Ratio ÷ Expected EPS Growth Rate

In conclusion, multiples are short-hand valuation metrics used to standardize a company’s value on a per-unit basis because absolute values can NOT be compared between different companies.

Given the company data in our modeling exercise was standardized, we can derive more informative insights from the comparison.

In lieu of the standardization, comparisons would be close to meaningless and it would be very challenging to determine whether a company is undervalued, overvalued, or fairly valued versus comparable peers.

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