Determining Company Value Using Valuation Multiples
Valuation multiples are a key component of financial modeling in assessing the value of a company.
It is based on the idea that similar assets will tend to sell at similar prices, equivalent to the concept of how three-bedroom/two-bath houses sell for around the same price as others in a particular geographical area in a particular economic environment.
It assumes that comparable firms – i.e., same size, same industry, same economy/location – can be valued using financial ratios relative to a company-specific value.
For instance, if we use the ratio EV/Sales and determine that this multiple averages 6.2x for our particular peer group, then multiplying the sales value of the firm we are looking to value by 6.2 should give us a reasonable approximation of the enterprise value (EV) of our company.
If our total sales figure was $200 million, our enterprise value of this company would be estimated at $200 million * 6.2 = $1.24 billion.
EV/Sales is one such financial ratio.
But there are multiple others that should be used in order to obtain a cross-comparative look at the enterprise values these multiples provide.
We will go through many of the most popular ones and explain the purpose behind their use.
Enterprise value-based metrics
- EV/EBIT
- EV/EBITDA
- EV/EBITDAR
- EV/EBITDAX
- EV/Sales
- EV/opFCF
- EV/FCF
- EV/DACF
- EV/NOPLAT
- EV/Invested capital
- EV/Capacity measure
EV/EBIT
EV/EBIT compares enterprise value relative to earnings before interest and taxes.
By taking out interest, the metric controls for forms of financing (interest payments) and influence based on jurisdiction (taxes).
EBIT is sometimes preferred over EBITDA as a denominator term given it figures in the intensity of a firm’s capital spending on asset accumulation.
EBITA is also used occasionally (earnings before interest, taxes, and amortization), to control for takeover history by removing amortization from intangible assets, such as brand name or patents owned by a firm.
EV/EBITDA
EV/EBITDA compares enterprise value relative to earnings before interest, taxes, depreciation, and amortization.
Unlike EBIT, EBITDA also controls for depreciation through capital expenditures and amortization through intangible assets.
EBITDA essentially serves as a proxy for free cash flow and is the most popular of the EV-based metrics.
EBITDA’s popularity surged in the 1980s.
For analysts, given the number of companies with positive EBITDA is higher than the number of companies with positive earnings, it also makes valuation by multiples easier.
A company with negative profits can’t have its earnings used to express a ratio – negative P/E ratios are meaningless.
But many companies have positive EBITDA because interest, taxes, depreciation, and amortization haven’t been subtracted out.
In finance, the term “EBITDA multiple” is used extensively to refer to the relative valuation of a firm.
Among mature companies, an EBITDA multiple of 8x to 12x is common.
EV/EBITDAR
EV/EBITDAR relates enterprise value to earnings before interest, taxes, depreciation, amortization, and rental costs.
This metric attempts to control for the same features as EV/EBITDA, but by including rental costs as well to account for firms that choose to rent rather than own many of their current operating assets.
EV/EBITDAR is mainly relevant in the retail, hotel/lodging, and transportation industries, but rarely applicable outside of it.
Even if a firm does rent many of its current operating assets to drive profit/revenue/net income, it would not be an appropriate multiple if other firms in its comparative peer group do not use the same tactic.
EV/EBITDAX
EV/EBITDAX is applicable in the oil and gas industries.
It compares enterprise value to earnings before interest, taxes, depreciation, amortization, and exploration costs.
Within the oil and gas industry, takeovers are common given the inherent thin margins in the industry (competition makes them worse). And firms with low EV/EBITDAX ratios are considered prime candidates.
It also serves as a strong metric when considering companies across national boundaries by controlling for tax effects.
EV/Sales
EV/Sales can be an effective measure when earnings are low or negative and may therefore disqualify the EBIT-related measures.
Sales are taken as equivalent to “net sales.”
This is common for startup valuation, growth equity, and in venture capital when dealing with companies that have revenue.
EV/opFCF
EV/opFCF takes a similar approach to EV/EBITDA but through the lens of operating free cash flow instead.
The opFCF metric is essentially dictated by the following formula:
opFCF = EBITDA – estimated capital expenditures – estimated net changes in working capital.
The capex figure is an amount estimated to be necessary for the firm to retain its current level of profitability and competitive stature within its industry.
Many analysts will prefer opFCF over EBITDA given it is cash-based and not affected by accounting procedures.
However, some may prefer EBITDA due to the estimations required to derive opFCF.
EV/FCF
EV/FCF is less subjective than EV/opFCF due to the absence of estimated quantities for capex and net changes in working capital.
Enterprise FCF is equal to the following:
FCF = EBITDA – actual capex – actual net changes in working capital.
This measure may eliminate the guesswork involved in opFCF.
But it also runs into the issue that capital expenditures are often an irregular form of spending and may not represent true average amounts, the same issue that opFCF sought to correct.
EV/DACF
EV/DACF controls for firms with high levels of leverage (debt).
Companies with higher debt levels can expect to have a higher EV/opFCF, which doesn’t reflect the higher financial risk inherent within the firm.
EV/DACF takes enterprise value and divides it by cash flow from operating activities in addition to any income tax, preferred shares, or interest expenses.
EV/NOPLAT
EV/NOPLAT (enterprise value / net operating profit less adjusted tax) is designed to better account for operating profitability.
NOPLAT is essentially EBIT after tax accounting adjustments. Or it can simply be EBI before accounting measures are taken to better reflect operating profitability.
Accounting adjustment may include adding back increases in bad debt, goodwill amortization, and interest expense on operating leases.
Another way of thinking about NOPLAT from a mathematical standpoint is the return on invested capital (ROIC) multiplied by the difference between the firm’s weighted averaged cost of capital (WACC) and long-term growth rate (g).
EV/NOPLAT can be a substitute for EV/EBIT but only when NOPLAT is calculated in the same fashion across companies.
EV/Invested capital
EV/Invested capital is the company-level equivalent to price to book value (P/BV).
Invested capital takes into account net working capital and tangible and intangible assets.
In some industries, assets are a key driver of earnings.
Usually, firms with a high K/L ratio (capital to labor) qualify as firms where the EV/Invested capital ratio would be useful, such as airlines and auto manufacturers.
EV/Capacity measure
EV/Capacity measure is a generalized metric that takes into account the ratio between enterprise value and some productive asset relevant to the firm’s profitability.
For example, a website could potentially be valued through EV/subscribers or EV/monthly traffic, as long it’s compared within the same niche.
The more subscribers a website has, the more clicks it is likely to generate, and the more advertising and other types of revenue it is bound to generate.
This would then generate an approximate value of how much each customer generates to the value of the site.
The EV/customers metric could be crudely applied to retail businesses. Or EV/audience for a theater.
Mathematical formulations of valuation multiples
Mathematically, many of these enterprise values can be measured as such:
EV/Sales
= (ROIC – g) / [ROIC * (WACC – g)] * (1 – T) * M
EV/EBITDA
= (ROIC – g) / [ROIC * (WACC – g)] * (1 – T) * (1 – D)
EV/EBIT
= (ROIC – g) / [ROIC * (WACC – g)] * (1 – T)
EV/NOPLAT
= (ROIC – g) / [ROIC * (WACC – g)]
EV/Invested Capital
= (ROIC – g) / [ROIC * (WACC – g)] * ROIC
or
= (ROIC – g) / (WACC – g)
EV/Capacity unit
= (ROIC – g) / [ROIC * (WACC – g)] * NOPLAT / Unit
Price to Earnings (P/E)
= (ROE – g) / [ROE * (COE – g)]
Price to Book Value (P/B)
= (ROE – g) / [ROE * (COE – g)] * ROE
or
= (ROE – g) / (COE – g)
PE to Earnings Growth
= (ROE – g) / [100 * g * ROE * (COE – g)]
Where:
- ROIC = return on invested capital; denotes how well a firm converts capital into profit
- ROE = return on equity; represents how profitable a firm is relative to the amount of capital invested by shareholders
- g = assumed long-term growth rate
- WACC = weighted average cost of capital
- COE = cost of equity or required return that investors expect
- T = effective tax rate
- D = depreciation and amortization as a percent of EBITDA
- M = operating margin, or revenue left over after variable costs are taken into account (e.g., wages, supplies); operating margin does not take fixed costs into account
Conclusion
Valuation multiples are highly useful when attempting to assess the market value of a business by using accounting or asset-based metrics as it relates to enterprise value.
When performing comparable company analysis, the multiples and peer group must be chosen appropriately in order to obtain a fair value reading of the business.
Failure to identify the suitable valuation multiples for the sector, and peer companies that are not chosen carefully by size, industry, and location/economy will distort the results of the valuation exercise.
But learning the various types of multiples will be useful for anyone pursuing any profession where valuation is used extensively, as comparable company analysis (“comps”) is the most pervasive financial model in this respect.
Related
- The Complete Guide to the Free Cash Flow to the Firm (FCFF) Valuation Model
- The Complete Guide to the Free Cash Flow to Equity (FCFE) Valuation Model