Using the Right Multiples
There are four basic principles that can help business owners and other companies apply multiples properly. These are: using peers with similar return on invested capital (ROIC) and growth projections, use of forward-looking multiples, use of enterprise-value multiples and adjustment of enterprise-value multiples for nonoperating items.
1. Use peers with similar prospects for ROIC and growth
Understanding what companies can be used to determine similar prospects for ROIC and growth can be difficult. One of the best places to start is by looking at a company’s industry. This is easier said than done as industries often are loosely defined. A good place to look at is a company’s annual report where it may list its competitors. Alternatively, one could use the Standard Industrial Classification codes.
Using an initial list of comparable, you must then examine each company and work out your answer to some critical questions, including why are the multiples different across the peer group?
If these advantages ultimately translate into better growth rates and ROICs, companies with an edge within a given industry will therefore trade using higher multiples, compared with those with lower ROICs and growth rates.
You will need to know how a company operates, what they sell, how profits are generated and how they grow in order to understand how multiples are used appropriately. Doing this successfully will mean you have a better aligned peer group.
2. Use of forward-looking multiples
Current evidence suggest that multiples should be based on forecast data rather than historical data. If there are no reliable forecasts available, ensure that the historical data that you use is as up to date as possible. Our recommendation is that you should use the most recent four quarters, not the most recent fiscal year, and discount eliminate one-time incomes or events. Forward-looking multiples tend to be more accurate predictors of business value.
3. Use enterprise-value multiples
Multiples of P/E are widely used but have two important shortcomings. First, the capital structure systematically impacts them. P/E ratios improve with leverage for businesses whose unlevered P/E (the ratio they would have if entirely financed by equity) is higher than one over the cost of debt. Thus, by exchanging debt for equity, a business with comparatively high all-equity P/E will falsely increase its P/E ratio by substituting debt for equity. Second, the P/E ratio is based on profits such as restructuring charges and write-offs. As these are often one-time events, multiples based on P/Es may be misleading.
The ratio of enterprise value to EBITA is one alternative to the P/E ratio. This ratio is less vulnerable to exploitation due to changes composition of capital. Since enterprise valuation comprises both debt and equity, and EBITA is the profit available to investors, there would be no systematic impact of a shift in capital structure. Changes can lead to a larger multiple only because such a move reduces the cost of capital. Even then, be sure to remember that enterprise-value-to-EBITA multiples still depend on ROIC and growth.
4. Adjust the enterprise-value-to-EBITA multiple for nonoperating items
Although EBITA is greater than earnings for estimating multiples for one-time nonoperating expenses in net profit, even multiples in enterprise-value-to-EBITA calculated for nonoperating items obscured within enterprise value and EBITA, both of which must be adjusted for these nonoperating items, such as surplus capital and operating leases. Failing to do will yield misleading outcome. Despite the general belief that multiples are straightforward to calculate, it takes time and work to accurately calculate them) Below are the most common things to consider.
Surplus capital and other nonoperating assets. Since EBITA excludes interest income from surplus capital, excess case should not be counted. Nonoperating assets must be independently assessed.
Operating leases. Businesses with substantial operating leases have an artificially low enterprise value and an artificially low EBITA. This is because the value of lease-based debt is ignored and rental expenses encompass interest costs. Although both impact the proportion in the same way, they do not act in the same magnitude. To calculate a multiple of enterprise value, add the value of leased assets to the current value of debt and equity. The next step is to add the implied interest expense to EBITA.
Stock options for staff. Add the current value of all employee grants currently pending to calculate the enterprise value. Be sure to subtract new employee option grants from EBITA.
Pensions. Add the current value of pension liabilities to calculate the enterprise value. To reduce the impact of nonoperating gains and losses related to pension plan assets, begin with EBITA, incorporate pension interest costs, exclude accepted returns on plan assets, and correct for any accounting adjustments emerging from changed assumptions (as per the company’s annual report).
Many multiples, albeit only in certain circumstances, may also be worthwhile. For examples,. price-to-sales multiples are of little utility to compare the valuations of various businesses. They presume that comparable companies have similar growth rates and ROICs. They also assume that the companies’ current businesses have similar operating margins. This constraint is unnecessarily burdensome for most businesses.
Non-financial multiples may help in valuing emerging businesses with limited revenues and negative profit, considering the great uncertainty around future market size, viability and any required investments. Nonfinancial multiples, such as page hits, new users, or the number of subscribers, equate business value to a non-operating metric. However, such multiples can only be used if they translate into stronger forecasts than financial multiples do. The non-financial metric is useless if a business cannot or does not convert visits, page hits or subscribers into income and cash flow.
In these cases, a multiple based on financial forecasts would provide a better outcome. Non-financial multiples are often just relative instruments; like all multiples, they simply calculate the value of one business compared with another.
However with this information in mind, it is important to note that the use of multiples may not always be applicable to your business.
Contact us for a free consultation of your business valuation.