What is a Multiple?
Investment Bankers talk a lot about valuation multiples. In fact, almost everyone in finance talks about multiples. Jim Cramer is probably talking about some company’s multiple right now.
Surprisingly, though, multiples and what they actually represent are deeply misunderstood by a frightening number of investment bankers (including, believe it or not, those that may be interviewing you on your super day).
So, let’s get right to it: “What is a multiple, really?”
I assume you’re comfortable with the basics: Multiples reflect the market’s perceptions of a company’s growth prospects, so two companies with similar prospects and operating characteristics should trade at similar multiples. And, if one is trading at a lower multiple than its “comparable” peers, then we can surmise that it is undervalued in the market. But is that all there really is to it? Why do multiples reflect a company’s growth prospects – and is that the only thing they reflect? What really underlies a multiple? What does it really mean to say that Microsoft trades at a 23.0x Share Price/EPS (P/E) multiple, or that Google trades at a 12.0x EV/EBITDA multiple?
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Intrinsic vs. Relative Value (Multiples Analysis)
Before we look under the hood of a multiple, let’s take a step back.
A common investment banking interview question goes as follows:
- “How do you value a company?”
To which, the prospective analyst or associate will be expected to respond that there are two major approaches:
- Intrinsic Valuation: The first one is called intrinsic valuation, which is where you calculate the present value (PV) of expected future free cash flows in order to discount them to the present date.
- Relative Valuation: The other approach – relative valuation – involves merely looking at the market values of comparable companies and applying those values to the company under analysis.
The distinction seems stark: the intrinsic approach suggests that the value of, say, a hot dog stand should fundamentally equal the present value of the cash flows it is expected to generate in the future, while the relative approach suggests that the value of the hot dog stand can be derived by looking at the value of comparable hot dog stands (perhaps one was sold recently and the purchase price is observable).
Role of Multiples in Valuation
A market-based valuation approach is a form of relative valuation where the price of an asset is determined by comparing it to its similar peers. Furthermore, multiples play a central role in relative valuation.
In our hot dog stand example, suppose a comparable hot dog stand, Joe’s Dogs, was purchased for $1 million several months prior to our hot dog stand being valued today.
If we know that Joe’s Dogs generated EBITDA of $100,000 in the last twelve months (LTM) prior to acquisition (that’s an Enterprise Value / EBITDA multiple of 10.0x), and we know that our hot dog stand generated LTM EBITDA of $400,000, we can apply the recently acquired EV/EBITDA multiple to our company, and estimate that we should expect a value of somewhere around $4.0 million for our hot dog stand today.
Arriving at value using multiples this way is a lot easier than projecting out cash flows each year and calculating a present value.
That’s why multiples analysis is ubiquitous in our world. While investment bankers use multiples all the time – in comparable company analysis, comparable transaction analysis, in LBO valuation, and even DCF valuation,* there is often confusion about what these multiples actually represent.
But are these valuation methods really distinct? If your gut tells you that there has to be some connection, you’re right. But how do we reconcile valuing companies intrinsically with valuing companies based on multiples?