Valuing a Target with Multiples
A multiple turns the value of a comparable business into a ratio, such as value relative to earnings or sales. Applying that ratio to a target's own figures gives an estimate of what the target is worth.
How a multiple estimates a target's value. A multiple is a ratio: a price or value divided by a measure of financial performance. If similar businesses are valued at a certain number of times their earnings, a target with similar characteristics is estimated to be worth roughly the same number of times its own earnings.
The logic is the one used when pricing a house by looking at what similar houses nearby are worth. The method does not build a value from scratch. It borrows evidence from the market and scales it to the target's size.
Comparable company multiples and transaction multiples. There are two sources of evidence.
Comparable company multiples come from similar businesses whose shares trade publicly. Their market values, set by investors day to day, are divided by their financial metrics. These reflect how the market prices such businesses as they are, without a change of control.
Transaction multiples come from past deals in which similar companies were bought. They are based on prices actually paid to acquire a business. Because buyers often pay for control and for expected benefits from combining, transaction multiples tend to sit above trading multiples. That difference is why the two are read side by side rather than mixed together.
Which metrics the multiples are built on. A multiple needs a denominator, a measure of the business's performance. Common choices include revenue, earnings before interest, taxes, depreciation and amortization (EBITDA), and net income. The choice matters because each metric tells a different story.
- Revenue works when profits are small or negative, but it ignores how profitable the sales are.
- EBITDA is a measure of operating performance that sets aside differences in financing and accounting for asset wear, so companies with different debt levels are easier to compare.
- Net income reflects everything, including financing costs, and is typically paired with equity value rather than the value of the whole business.
The value in the numerator has to match the metric in the denominator. A metric from before financing costs pairs with the value of the whole business, and a metric from after financing costs pairs with the value of the shares.
Why the choice of peers matters. The result is only as good as the peers behind it. Peers should resemble the target in industry, size, growth, profitability and risk, because those traits drive what investors and buyers are willing to pay.
A peer in a faster-growing or less risky business carries a higher multiple, and applying it to the target overstates the value. Peers that are far smaller, or in a different line of business, distort it the other way. Selecting peers is therefore a judgment, and different sensible selections give different answers. That is one reason the output is a range rather than a single number.
Calculating an implied value range from peers. The steps run as follows. Calculate the multiple for each peer. Find the low and high ends of those multiples, along with a middle figure such as the median. Multiply each by the target's own matching metric. The results form the implied value range.
For example, if the peers' EBITDA multiples run from 6 to 10 with a median of 8, and the target's EBITDA is 50 million, the implied value of the whole business runs from 300 million to 500 million, with 400 million in the middle.
