Guidelines on Multiples Valuation
In addition to the Discounted Cash Flow (DCF) approach, one can use a multiples-based approach to value a firm.
A multiple represents a market price per unit – we obtain the value of the units by taking a product of the multiple
and the number of units. For example, when we multiply the (prevailing) price per square foot of a property (the
multiple) by the square footage of the property (the number of units), we obtain the value of the property. [Note that
properties with the same square footage may not sell for the same price if they differ in terms of quality, location,
amenities, etc.]
Valuation Multiples
A Valuation Multiple is a ratio of the firm (or equity) value to some measure of the firm’s scale (such as cash flow
or EBITDA). The multiples derive from valuation techniques that we are familiar with.
We estimate the value of the firm based on the value of other comparable firms or investments that we expect will
generate very similar cash flows in the future. Note that two firms, while similar along several dimensions, are likely
to be of a different size or scale. We can adjust for scale differences between firms by expressing their value in terms
of a valuation multiple.
Firm-Value Multiples: Recall that firm value represents the entire value of the firm before the firm pays its debt.
Therefore, to form an appropriate multiple, we must divide firm-value by a measure of earnings or cash flows before
interest payments are made.
For example, common multiples include enterprise value to EBIT, EBITDA, and free cash flow. Because capital
expenditures can vary significantly over time, most practitioners rely on enterprise value to EBITDA multiples. Other
multiples used are the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio.
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Fin 553: Multiples Valuation
Relative to the DCF approach, the use of multiples requires few calculations and provides a quick means to estimate
value. However, we must ensure that the firm characteristic (such as EBITDA) must be comparable to that for the
group of firms used as comparables. Therefore, it is very important to select the comparables appropriately.
When computing trading multiples,
- identify firms with similar prospects
- ensure that CF (or EBITDA) is expected to grow at a similar rate across the comparables
- compute value (V = D + E) for each firm
- compute the ratio of V to the economic characteristic (such as CF, EBITDA)
- compute the multiple as an average/median of the multiples of the comparables
We follow essentially the same steps (as above) when computing transaction multiples. Here, we focus on firms that
merged (or were acquired) and work with value paid for comparable firms in a merger or acquisition. V equals the
sum of D and the amount paid for equity (E). Note that the price paid in the transaction includes a premium for
control and (expected) synergies.
Limitations of Multiples
The usefulness of a valuation multiple will depend on the nature of the differences between firms and on how
sensitive the multiple is to these differences. When valuing a firm using multiples, there is no clear guidance (other
than narrowing the set of comparables) on how to adjust for differences in expected future growth rates, risk, or in
accounting policies across firms.
Comparables only provide information regarding the value of a firm relative to other firms in the comparison set.
Using multiples will not help us determine if an entire industry is overvalued. In contrast, discounted cash flow
methods have the advantage that they can incorporate specific information about the firm’s cost of capital or future
growth. Since the ability to generate cash flows (for the investors) is the true driver of value for any firm, the
discounted cash flow methods have the potential to be more accurate than the use of a valuation multiple.
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Fin 553: Multiples Valuation