M&A Fundamentals – The Multiples Method of Business Valuation
Multiples valuations are the simplest and most intuitive way to put a value on a M&A target. This method of valuing an M&A target is sometimes called the Market Method of valuation because it is based on the price of comparable shares sold on a stock exchange, or the value of other companies sold in an M&A transaction.
Valuation multiples are ratios of one or more metrics of a company to its value. This ratio becomes a benchmark that can be used to value other companies, and specifically M&A targets. The metrics used as the basis of the ratios are often financial measures such income, cash flow or revenues, but they can also be physical measures such as the number of customers.
The Main Types of Valuation Multiples Used for M&A Transactions
Equity multiples are derived from the market capitalisation of listed companies (companies traded on stock exchanges). The most frequently used equity multiple is the price earning (PE) ratio. The PE ratio is:
Earnings per Share / Latest Share Price.
You might find this easier to understand as:
Profit After Tax / Market Capitalisation.
PE ratios for every listed company are freely available on the websites of stock exchanges, and any number of financial information services. They are widely used by financial analysts and M&A professionals both to compare performance between companies, and to put a value on M&A targets.
As listed companies are required to publish detailed financial information it is relatively easy to us other financial metrics,. such as cash flow (EBITDA), and revenues as the basis of alternative ratios.
ENTERPRISE VALUE MULTIPLES
Equity valuations based on market capitalisation are meaningful only for companies listed on stock exchanges. The vast majority of M&A transactions are for private companies or commercial assets purchased from other corporations. These M&A transactions will be valued as a ratio of enterprise value rather than market capitalisation.
Enterprise value (EV) measures the total value of a company in contrast to an equity valuation of an M&A target that only reflects its “market capitalisation”. It is easiest to understand enterprise value by thinking of the route we would take to get from the market capitalisation of a listed company to its enterprise value. The formula is:
Enterprise Value = Market Capitalisation + Control Premium + Net Debt.
We explain enterprise value, and its importance in M&A, in more detail in another article in this blog.
When an M&A professional makes an offer for an M&A target the consideration is universally based on the enterprise value of the M&A target.
THE MOST COMMON EARNINGS TO ENTERPRISE VALUE MULTIPLES
Most enterprise value multiples are earnings or cash flow multiples. The most common multiples are:
Enterprise Value / EBIT (Earnings Before Interest and Tax)
Enterprise / EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). EBITDA is used as proxy for cash flow.
Enterprise Value / EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortisation and Research and Development). This measure is often used to value early-stage companies that are reaching the end of the development phase of a new product or service.
The underlying principle behind earnings multiples is that there is a strong correlation between earnings and the value of a company. This certainly reflects the intuitive opinion of most buyers of M&A targets.
The earnings multiple approach assumes that a relationship between earnings and value can be established for an industry sector, and that this multiple can then be used to derive value for any company in the industry. Once an industry multiple has been calculated it can be used to value both listed and unlisted M&A targets.
OTHER ENTERPRISE VALUE MULTIPLES
There are circumstances where EV ratios other than earnings or cash flow are considered more suitable to value an M&A target.
Enterprise Value / Revenues. Used for loss making companies or sectors where there is a well understood relationship between revenues and costs – for example professional practices and restaurants.
Enterprise Value / Invested Capital. Used in capital intensive industries and especially in highly regulated sectors where the regulator might set a relationship between assets employed and earnings.
Enterprise Value / Operationally Based Measure. Used in sectors with where there is a well understood relationship between an operational measure and earnings – for example oil and gas companies and reserves, mobile phone companies and connections, or social media companies and live accounts.
Sources of Data for Multiples
Multiples can be calculated for quoted companies based on their share price, but for many M&A professionals the most credible source of information is the multiples actually paid for companies in reported deals.
There are two main methods of analysis used to arrive at the ratios to be used as multiples to put a value on an M&A target.
COMPARABLE COMPANY ANALYSIS
Where the M&A professional builds a population of listed companies that are considered comparable to the M&A target. The M&A professional will then calculate ratios (multiples) of various financial metrics to the “market capitalisation” and the “enterprise value” of each of the comparable companies.
Diagram 1: Illustration of a comparable company analysis
PRECEDENT TRANSACTION ANALYSIS
Where the M&A professional builds a population of prior M&A transactions involving companies similar to the M&A target. If sufficient information is available to work out the ratio of income, or cash flow or revenues to the price paid for the precedent M&A transaction these ratios can be used to put a value an M&A target. A relevant precedent transaction is in many ways the gold standard of M&A valuation. It shows the price paid by other M&A professionals for a similar M&A target involved in an M&A transaction.
Diagram 2: Illustration of a precedent transaction analysis
Using the Multiples for Valuation
When the M&A professional has finished analysing the relevant comparable companies and precedent transactions they are in a position to prepare the valuation of the M&A target. Diagram 3 illustrates a relatively simple layout for a valuation calculation.
In this scenario Timpson Enterprises, one of the buyers in the precedent transaction analysis table laid out in Diagram 2, is the potential M&A target of a larger enterprise in the same industry. The M&A professional tasked with preparing the valuation has decided to use the average multiples from the precedent transaction analysis and apply it to Timpson Industries’ most recent financial statements.
Diagram 3: Illustration of multiples valuation format
In practice the valuation calculation is rarely this straightforward. The M&A professional might feel the latest financial year of the M&A target is unrepresentative of a typical year. They may choose instead to take an average of recent years performance, or adjust the financial statements for the impact of a one-off event.
The M&A professional might also question the use of a market average multiple for this M&A transaction. Perhaps one of the precedent transactions in the analysis is a very close fit for Timpson Enterprises. This may be because of size, the specific products and services the company sells, or some other factor.
Advantages and Disadvantages of Multiples Valuations
The simplicity of multiples calculations and the underlying concepts makes them easy to explain to senior executives with non-financial backgrounds. This simplicity, coupled with the intuitive reinforcement that the ratios are based on the sale of a comparable enterprise, makes a multiples valuation in the eyes of many senior executives the most credible tool for putting a value on an M&A transaction. There is no doubt that multiples of income or cash flow set expectations on both sides of an M&A transaction.
On the flip side, the same simplicity can also be considered a disadvantage. Multiples valuations reduce complex information to just a single value. This is a considerably less sophisticated analysis than forecasting the various elements of cash flow forward in a present value discounted cash flow calculation. Reduction to a simple ratio can hide the impact of both negative and positive factors. In essence a multiples valuation is based on a snapshot of a company’s situation at a point in time. It does not reflect a company’s ability to grow, or perhaps decline, over time.
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