Managing value through multiples

Here, we offer an overview, in the context of mergers and acquisitions, of multiples based valuation and look at the main advantages and limitations of this approach.

As an in-house lawyer, you’re likely to be heavily involved if your organisation acquires, or merges with, another business or decides to sell some or all of its operations and assets.

With this in mind, a working knowledge of the multiples valuation approach will be to your advantage.

When it comes to working out how much a project, division or indeed an entire business is worth, financiers have traditionally relied on the discounted cash flow (DCF) method. This entails estimating the future cash flow, then discounting it against the cost of capital investment that will be needed in order to generate that cash flow to arrive at a present value.
However, there are two problems with this approach. Firstly, it’s time-consuming as there are many factors to verify and factor in to the calculation. Secondly, it can produce unreliable results as the calculated value is only as good as the best forecasts for a range of underlying variables.

With this uncertainty in mind, more and more financiers are turning to a methodology based on multiples of profitability or earnings. As well as being an effective valuation technique in and of itself, the multiples approach can also act as a useful cross-check for the DCF method.

What is the multiples approach?

At its heart, the multiples approach is based on a very simple formula, where:

Value = earnings x multiple

This formula looks simple, but don’t be deceived. It masks some subtle, yet complex issues. Let’s look at some of these.

Maintainable earnings

The first and most obvious question that arises from the formula is, “What definition of earnings (or profits) should we use?”

Financial analysts aim to determine maintainable earnings. This term refers to the sustainable profits a business generates, so strips out the value of one-off or unusual items such as:

  • Gains from asset sales;
  • Fixed asset leases;
  • The impact of excessive pension liabilities;
  • Stock option grants;
  • Exotic capital structures; or
  • Unusual accounting policies.

The aim is to ascertain the sustainable level of earnings the business under consideration can generate and /or what it could achieve by enhancing its operating procedures.

Comparable multiple

The second key question is, “What is an appropriate multiple?”

Multiples, especially the price-to-earnings (PE) ratio for publicly traded companies are published in newspapers, by data providers such as Bloomberg and through information released by investment analysts. It would, therefore, be tempting to take a simple average of all the companies evaluated in the same sector as the business being considered.

A superior approach is to look more carefully for what are often termed comparable companies. For a multiple to be meaningful, it should be based on companies that are as similar as possible to the business under consideration. This means taking factors such as size, geographical spread, growth rate, operating margin and capital structure into account.

The advantage of this is that it would avoid the error of applying a multiple from a small, fast-growing new entrant to a large, mature industry incumbent.

The difficulty, of course, is that the number of directly comparable companies is usually very limited. This means corporate financiers have to use their judgement and industry knowledge and, where they feel appropriate, adjust the reported multiples for the factors we mentioned above.

Another way is to examine merger and acquisition transactions for comparable businesses and impute the implied multiple at which those businesses were purchased. After all, there’s no better test of how investors value a business than how much was actually paid for a similar one. However, once again, a prior assessment must be made on how comparable the acquired company is in relation to the business under consideration.

Determining appropriate maintainable earnings and a suitable multiple calls for great skill, judgement and care. There’s a lot more to it than simple multiplication.

Common multiples

The three most commonly used financial multiples are:

  • P/E ratio – the most widely used multiple by financial analysts, this is the multiple of a business profit after tax as reported in the profit and loss account. Its main weakness is that it mixes all operating and non-operating items, so requires a lot of adjustments to arrive at the maintainable figure;
  • EBIT ratio – EBIT stands for earnings before interest and tax. This multiple is used to eliminate the effect of different capital structures (primarily the level of debt financing) on earnings; and
  • EBITDA ratio – EBITDA stands for earnings before interest, tax, depreciation and amortisation. Analysts typically use EBITDA to compare companies which have large amounts of fixed assets, be they tangible or intangible.

Analysts use both historic (based on the last reported financial statements) and forecast (based on the best available estimates of future financial performance) multiples. Where reliable data is available, especially for comparable companies, forecast multiples are preferred as analysts assume current market values reflect expectations of future performance.

Other multiples

In addition to these three common multiples, many industry sectors have their own specific ratios which act as rules of thumb or cross checks for more formal valuation methods. Examples include:

  • Price-to-turnover;
  • Value per customer/user; and
  • Value per store/location.
  • Advantages of a multiples approach

The three main advantages of the multiples valuation approach are that:

  • Compared to a full DCF calculation, it’s relatively quick and easy, with the necessary data usually readily available, especially in developed markets;
  • It utilises a widely-adopted, standardised approach so is well understood by market analysts and corporate managers; and
  • It’s market based, so reflects current investor confidence and expectations.

Limitations of a multiples approach

The multiples approach does, however, have its limitations. For example:

  • Corporate managers, particularly those whose remuneration is tied to related metrics, can be incentivised to manipulate earnings through unusual accounting policies or one-off transactions. 
  • Analysts, therefore need to examine the earnings of both the target business and comparables very carefully;
  • Being explicitly market based, it’s skewed by the economic and investor confidence cycle. Businesses can be over-valued during booms and under-valued during recessions. In addition, there’s no explicit link between the valuation and fundamental economic forces;
  • It ignores the presence of surplus assets or potentially large future liabilities; and
  • It’s of limited value in the case of loss-making or early-stage, high growth companies where earnings multiples are either not possible or highly skewed.

Conclusion

The multiples approach to valuing a business is increasingly preferred to the discounted cash flow (DCF) method that was once the gold standard among corporate financiers. The approach is based on a formula where value is equal to earnings multiplied by the multiple. This means analysts must use the best information available and apply some adjustments and, at times, judgement to compute a business’s maintainable earnings. They then decide from a range of options how best to calculate the multiple. The multiples approach to valuing organisations has some compelling advantages over the DCF method, however, at the same time it pays to be aware of its limitations.