How do you communicate and justify your exit multiple assumptions to stakeholders and investors?

Another way of assuming exit multiples is by using the current EV/EBITDA or EV/FCFF multiples of the underlying company being valued. We could then add a premium or a discount to current multiples driven by assumptions of future growth in profitability/FCFF vs historical levels.

The difficulty in using exit-mulitples as terminal value proxies in DCF lies in the fact that any multiple is heavily influenced by the future outlook. A EBIT multiple can be seen as an implied inverse proxy for payback period. If EBIT Multiple today is 5, this means ceteris paribus an investor is willing to wait 5 years to get back money invested. In the case of an exit multiple in DCF where we usually plan 3-5y ahead defining the exit multiple means to make assumptions about additional 5 years after the defined planning horizon within the DCF model. Therefore in order to make reasonable assumptions about Exit Multiples means much more than estimating current Exit Multiples and assuming that they are going to be constant for the next 10y.

Employ a data-driven approach: transaction Comps: filter deals within a +/- 20% EBITDA margin and +/- 3-year vintage window of our target to mitigate selection bias. DCF Analysis: calibrate WACC using a 10-year beta and risk-free rate, and model long-term growth at industry averages. Sensitivity analysis assesses the impact of a +/- 10% change in exit multiples on IRR and DPI. Strategic Buyer Analysis: prioritise acquirers with a history of deals exceeding 2x target EBITDA within the past 5 years to strengthen the strategic premium justification. Present a range with justifications for each method, acknowledging the inherent uncertainties in exit timing >20% variance and market conditions. This fosters transparency and stakeholder trust.

The most common approach leverages market comparables. - Identification: We find companies comparable in size, growth stage, profitability, and industry. - Financial Data Collection: We gather relevant financial data (e.g., EBITDA, revenue) for these comparable companies. - Multiple Calculation: We calculate the exit multiples used in past transactions for these companies (e.g., Enterprise Value / EBITDA). Applying the Multiple: We apply the average or median multiple from the comparables to our company's projected financial metrics in the terminal year.

We also need to take into consideration the underlying risk to cash flows and the business model vs comparables to derive the premium/discount on multiples.

Analysts can leverage regression analysis, a statistical workhorse. This technique isolates the relationship between variables: Data Collection: We gather historical financial data for relevant comps, including growth rates, EBITDA margins, and exit multiples. Model Building: A statistical model is built to quantify the impact of growth and margin variations on exit multiples within the comp set. Tailored Exit Multiple: By inputting your company's projected growth and EBITDA margin for the terminal year, we arrive at a more bespoke exit multiple.

One way to derive the premium/ discount of exit multiples is to gauge where current valuation multiples sit vs historical ranges. For instance if current EV/EBITDA multiple is trading at 8x vs historical range of 8x to 12x. We can assume with some level of confidence given an assumption in market conditions turning favorable in the future that the multiple will revert back to at least it's average range of 10x.

Market comparables and regression analysis provide a solid foundation for exit multiple estimation, but they're just one piece of the puzzle. Here's why: - Market Fluctuations: The market is a dynamic beast. Exit multiples can fluctuate based on factors like capital supply, financing availability, competition, etc. - Future-Proofing Your Valuation: To address this dynamism, consider how the market might evolve by the exit time. A potentially more favorable market could justify applying a premium to the base exit multiple. Or a less favorable outlook could warrant a discount - Refined Exit Multiple: By incorporating these future-oriented adjustments, you arrive at a more nuanced and market-sensitive exit multiple.

One key sanity check is to determine the implied long term growth rate of the selected terminal growth rate - does this growth rate makes sense in light of the market segment and also the implied growth rate of the comparable companies.

Simple rule: Err on the side of conservatism for exit multiples. This isn't an episode of The Price is Right. This is about reducing the probability of loss as much as possible. Use the Minimum of all 3 methods listed above - Comparables, Adjustments for Margins and Growth, Market Conditions (current and historical). If the investment works (good enough return or IRR) even in this conservative scenario, great. If not, move on to something else.

Most important to me is to always keep in mind the big picture and factor in to some extent foreseeable future trends and transformations. Short-term precision is one thing, but in the long run a whole industry might disappear within 5 years and how do you justify any Exit-multiple in your DCF model in that case? Any exit multiple at the end of the day implies that an asset is sellable after the end of the planning horizon, so you need to make sure (and make investors believe) that the asset will be indeed sellable after this period.

Err on the side of conservatism for exit multiples for public equities. Regardless of how high recent market multiples have been, I consider 20X future free cash flow as the upper limit on exit multiples for companies that, in my opinion, have a durable competitive advantage. For the lower bound, it’s influenced by historical industry multiples (average or median) depending on how reliable the distribution of historical multiples is (often the distribution is so wide that an average or median has little utility). The underlying message in this approach is: bet on rationality rather irrational exuberance. This is easier to explain to myself and to others because is reasonable and lucid and it allows me to sleep well at night.

Accept that assumptions are just that, one's best guess. Support realistic goals and the means to achieve the goals. Otherwise the assumptions are just wild a** guesses (or WAGs).