What is a Valuation Multiple?
A Valuation Multiple is a ratio that reflects the valuation of a company in relation to a specific financial metric. Usage of a valuation multiple – a standardized financial metric – facilitate comparisons of value among peer companies with different characteristics, most notably size.
How to Calculate Valuation Multiples (Step-by-Step)
The basis of relative valuation is to approximate the value of an asset (i.e. the company) by looking at how similar, comparable companies are valued by the market.
The median or mean of the industry peer group serves as a useful point of reference to determine the worth of the target company.
A valuation using comps has the distinct advantage of reflecting “reality” since the value is based on actual, readily observable trading prices.
However, the absolute value of companies – such as equity value or enterprise value – cannot be compared on their own.
A simple analogy is comparing the prices of houses – the absolute prices of the houses themselves provide minimal insights due to size differences between houses and other various factors.
Therefore, standardization of the valuation of companies is required to facilitate meaningful comparisons that are actually practical.
Valuation Multiple Formula
A valuation multiple comprises two components:
- Numerator: Value Measure (Enterprise Value or Equity Value)
- Denominator: Value Driver – i.e. Financial or Operating Metric (EBITDA, EBIT, Revenue, etc.)
The numerator is going to be a measure of value, such as equity value or enterprise value, whereas the denominator will be a financial (or operating) metric.
A mandatory rule is that the represented investor group in the numerator and the denominator must match.
Note that for any valuation multiple to be meaningful, a contextual understanding of the target company and its sector must be well-understood (e.g. fundamental drivers, competitive landscape, industry trends).
Hence, operating metrics that are specific to an industry can also be used. For example, the number of daily active users (DAUs) could be used for an internet company, as the metric could depict the value of a company better than a standard profitability metric.
Types of Valuation Multiples: Numerator and Denominator
For a valuation multiple to be practical, the represented capital provider (e.g. equity shareholder, debt lender) must match in the numerator and denominator.
- Enterprise Value: If the numerator is enterprise value (TEV), metrics such as EBIT, EBITDA, revenue, and unlevered free cash flow (FCFF) could be used as the denominator since all of these metrics are unlevered (i.e. pre-debt). Thus, these metrics coincide with enterprise value, which is the valuation of a company independent of the capital structure.
- Equity Value: Conversely, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and earning per share (EPS) can be used since these are all levered (i.e. post-debt) metrics.
Enterprise Value Multiples vs. Equity Value Multiples
In the chart below, some commonly used enterprise value and equity value-based valuation multiples are listed:
Enterprise Value Multiples | Equity Value Multiples |
Note that the denominator in these valuation multiples is what standardizes the absolute valuation (enterprise value or equity value). Similarly, homes are often expressed in terms of sq. footage, which helps standardize value for differently sized homes.
Based on the circumstances at hand, industry-specific multiples can oftentimes be used as well. For example, EV/EBITDAR is frequently seen in the transportation industry (i.e. rental costs are added back to EBITDA) while EV/(EBITDA – Capex) is frequently used for industrials and other capital-intensive industries like manufacturing.
In practice, the EV/EBITDA multiple is the most commonly used, followed by EV/EBIT, especially in the context of M&A.
The P/E ratio is typically used by retail investors, while P/B ratios are used far less often and normally only seen when valuing financial institutions (i.e. banks).
When it comes to unprofitable companies, the EV/Revenue multiple is frequently used, as it’s sometimes the only meaningful option (e.g. EBIT could be negative, making the multiple meaningless).
Trailing vs. Forward Multiples: What is the Difference?
Oftentimes, you’ll come across comps sets with forward multiples. For example, “12.0x NTM EBITDA”, which simply means the company is valued at 12.0x its projected EBITDA in the next twelve months.
Using historical (LTM) profits have the advantage of being actual, proven results, which is important because EBITDA, EBIT, and EPS forecasts are subjective and especially problematic for smaller public firms, whose guidance is less reliable and harder to obtain.
That said, LTM suffers from the problem that historical results are typically distorted by non-recurring expenses and income, misrepresenting the company’s future, recurring operating performance.
When using LTM results, non-recurring items must be excluded to get a “clean” multiple. In addition, companies are regularly acquired based on their future potential, making forward multiples more relevant.
Therefore, rather than picking one, both LTM and forward multiples are often presented side-by-side.
Comparable Companies Analysis Output Sheet (Source: WSP Trading Comps Course)