Lesson #3: Introduction to Multiples Valuation

When valuing a company, there are several approaches you can take, but one of the most popular methods is multiples valuation. Understanding how and when to apply multiples is crucial for anyone working in corporate finance or investment banking.

In today’s newsletter, we’ll break down what multiples are, the different types you should know, and how to use them effectively to assess company valuations.

What Are Valuation Multiples?

Multiples valuation is a relative valuation method where a company’s financial metrics are compared to those of similar companies in the same industry. By using these multiples, you can get a quick idea of whether a company is overvalued or undervalued. This method is most often used when conducting mergers and acquisitions (M&A) or during investment decisions.

In the simplest terms, multiples show the relationship between a company’s value and a relevant financial metric, such as earnings or sales. For example, a company’s Price-to-Earnings (P/E) ratio or its Enterprise Value to EBITDA (EV/EBITDA) can help assess its market value against other firms in the same industry.

For example, if a company is making $100 million in net income, and other similar companies are trading at 11 times that figure, the company in question would have an expected market value of $1.1 billion.

Main Types of Valuation Multiples

1.????? Earnings-Based Multiples Earnings multiples like Price-to-Earnings (P/E) and Enterprise Value-to-EBITDA (EV/EBITDA) are commonly used to assess profitability. These multiples focus on how well a company performs in generating earnings relative to its market price.

• P/E ratio: Useful for comparing companies based on their earnings and determining how much investors are willing to pay for $1 of earnings.
• EV/EBITDA: This multiple is important when analyzing companies in capital-intensive industries or those with large depreciation expenses, as it excludes the impact of financing and non-cash expenses.

2.????? Sales-Based Multiples When a company isn’t yet profitable, sales-based multiples like Price-to-Sales (P/S) or EV-to-Sales become useful. These multiples allow you to assess a company’s value based on its top-line revenue rather than profits. While these multiples are easier to calculate, they don’t account for profitability, making them less reliable on their own.

• P/S ratio: Measures how much investors are willing to pay for every dollar of revenue a company generates.

3.????? Industry-Specific Multiples For certain industries, traditional metrics like earnings or sales may not provide a full picture. In such cases, industry-specific multiples are used. These could include measures like Price-to-Book (P/B) ratio or multiples based on the company’s operational metrics, such as customers, units sold, or other key performance indicators.

• Example: For banks, Price-to-Book (P/B) is often used as a key metric to compare companies’ market value to their book value.
• Example: For technology firms, metrics such as Active Users or Monthly Visitors can be used to determine market value.

4.????? Transaction Multiples Transaction multiples are used to assess the price paid for a company in an acquisition or merger. The most commonly used transaction multiples include EV/EBITDA, EV/Sales, and P/E ratios. These multiples give an indication of how much buyers are paying relative to key financial metrics during an M&A transaction.

How to Use Multiples Valuation in Practice

Multiples valuation is a quick and effective way to estimate a company’s value, but it should not be used in isolation. To make the most informed decisions, multiples should be used alongside other methods like Discounted Cash Flow (DCF) analysis, which provides a deeper dive into a company’s future cash flows.

When applying multiples, it’s essential to:

• Compare companies within the same industry.
• Consider using different multiples to cross-check results.
• Adjust for key differences between companies, such as size or market conditions.

Let’s say you’re considering an investment in a software company that is not yet profitable. You would most likely use an EV/Sales multiple for valuation, as the company’s sales figure will give you a better indication of its worth than its earnings at this stage. By comparing this multiple to other software companies, you can determine if the company is undervalued or overpriced relative to its competitors.

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Get Better Today

If you’d like to learn more about how to effectively use multiples in your analysis, consider enrolling in our Multiples Valuation course, which provides hands-on training and real-world case studies. By the end of the course, you’ll have the tools to confidently analyze companies using multiples and other methods.

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