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The choice of valuation multiples for private companies – which is the best

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The choice of valuation multiples for private companies - which is the best

The market approach is one of the widely used valuation techniques for private company valuation. Here the subject private company is benchmarked against a set of public comparables (public comps) or comparable transactions (Transaction comps). Valuation multiples are computed for the comparable set, which acts as the basis to derive a valuation for the subject.

A valuation multiple is a ratio between two numbers, where the Numerator is a Value measure such as Enterprise value (EV), Market value of invested capital (MVIC), or Share price (P), and the Denominator is a value driver such as Sales, EBITDA, EBIT or Net Income, etc. Ideally, the value measure in the numerator and the value driver in the denominator should be economically related to each other, e.g., EV or MVIC should be used along with either Sales, EBIT, or EBITDA as both are firm-wide measures; similarly, Price should be used with Net income or Free cash flow to Equity (FCFE) as both are Equity wide measure.

In this blog post, we will discuss some of the most widely used Value multiples and their application for private company valuation.

Choice of EV, MVIC, or Price as a value measure

Both EV and MVIC are firm-wide measures, whereas Price is an Equity wide measure. Firm-wide measures are more appropriate for companies with a volatile capital structure where it is challenging to forecast the debt-Equity mix. Conversely, for companies where forecasting the debt mix is possible or where debt act as raw material rather than a source of capital, such as financial service companies, equity-wide measures can be preferred.

Between EV and MVIC, MVIC is more appropriate for high growth cash burning companies where cash is going to be invested to generate top-line growth, as MVIC is a value measure that includes Cash. For relatively stable and matured companies where the cash balance in the Balance sheet is stabilized, EV can be preferred over MVIC. However, in practice, both EV and MVIC are used widely for all types of companies.

A detailed look into the most widely used Valuation Multiples

  1. Enterprise Value or MVIC-based multiples. Choice of value drivers includes:
    • Revenue: Revenue-based multiples do not consider the operating cost structure of a company. Two companies with equal revenues might not have the same valuation due to differences in their profit margins and reinvestment needs. Companies which have high operating leverage, their revenues are much less volatile as compared to their operating earnings, making Revenue a better value driver for such companies. It can even be used for companies that are yet to become profitable. Revenue is also less sensitive to accounting distortions.
    • EBITDA: EBITDA is a more holistic value driver than revenues as it considers the operating cost structure of a company. EBITDA is more appropriate for capital-intensive businesses with varying depreciation policies as EBITDA does not consider Depreciation & Amortization (D&A) in the calculation.
    • EBIT: The difference between EBITDA and EBIT is non-cash expenses such as Depreciation & Amortisation (D&A). EBIT is EBITDA minus D&A. For less capital-intensive companies, EV/EBIT might provide a more accurate valuation than EV/EBITDA as it counts D&A as actual expenses representing utilization of company assets. However, both EBITDA and EBIT are more exposed to accounting manipulations than revenues.
    • SDE: SDE stands for Seller’s discretionary earnings. SDE is EBITDA plus owner compensation. Owner compensation is the personal expenses of business owners, which are paid by the business to save taxes. But at the time of valuation company wants to readjust these expenses to present a better picture of the company. So SDE is always higher than EBITDA. The use of SDE is more common in smaller companies or sole proprietorship businesses.
    • FCFF: FCFF stands for Free cashflow to firm. FCFF is computed in the following manner:

      [( EBIT *(1-tax rate))+ D&A – Working capital investments – Capex].

      FCFF is the net cash flow generated in a given period for all suppliers of capital (debt and equity) after accounting for all operating expenses, capital expenses, taxes, and working capital requirements. Young, high-growth companies usually have negative FCFF, making it an inappropriate value driver. However, for relatively mature companies with positive FCFF, it can be a very holistic measure, as FCFF considers the reinvestment needs as well to sustain future growth.
  2. Price-based Multiples – Price-based multiples are not as common in private company valuation as EV or MVIC-based multiples. However, they can be used to get to Equity value straight. Price here refers to the Value of equity or Market capitalization; as mentioned earlier, it is an Equity wide measure. The following could be used as value drivers:
    • Net Income (or EPS): Unlike EBITDA or EBIT, Net income (NI) is an Equity-wide measure, making it more appropriate to use in the denominator when we have Price in the numerator. Net income is a very holistic measure. It takes into effect both operating and non-operating expenses and provides income attributable to Equity holders. However, For young and high-growth private companies, Net income might be negative; in that case, Price to Earnings cannot be used. Usually, net income is more prone to accounting manipulations than Revenues or Gross profits.
    • Book value of Equity: The book value of equity represents the total equity capital invested by the equity holders in the company so far. A Price to Book (PB) ratio greater than one represents that company has created value for its owners; a PB of less than one represents the destruction of value. Book value of equity is a more appropriate value driver in the case of financial service companies such as banks, insurance companies, etc., where balance sheet values are much closer to their fair market values. Book value of equity is more sensitive to accounting manipulations making it a less reliable measure; if the quality of reporting is not up to the mark. If a company is incurring losses for a long time, then even the Book value of Equity can be negative.
    • Revenues: Price to Sales (PS) ratio is also a popular value multiple. It is especially useful where Net income or Book value is either negative or unreliable. Sales are lesser sensitive to accounting manipulations than NI or Book value of equity. However, as mentioned earlier, two companies with equal revenues might not have the same valuation due to differences in income margins, making revenues a less appropriate value driver than income measures.
    • FCFE: FCFE refers to Free cash flow to Equity. It is computed as follows: [((EBIT)*(1-t))+ Dep – Interest expense – Working capital investments – capex + Net borrowing].
      FCFE is the cash generated in a given period for equity investors after accounting for all operating expenses, capital expenses, working capital needs, and debt-related payments. FCFE is a cashflow measure which makes it less sensitive to accounting manipulations. It is a holistic value driver for equity valuation.
    • Earnings/Growth: PE/G ratio, commonly known as PEG ratio, is another widely used value multiple in equity valuation. PEG is computed by dividing the PE (Price/EPS) ratio by the expected EPS growth rate. The PEG ratio provides a more holistic view of relative valuation than a PE ratio. A company with lower than industry average PE may not necessarily be undervalued. It might be due to its lower growth forecast. However, estimating the PEG ratio requires a forecast of future growth, which brings lots of subjectivity to the analysis.

All of the above-mentioned value drivers can be computed on LTM (Latest twelve months) basis or forward-looking basis. Empirical evidence favors the use of forward-looking multiples as they have proven to be more accurate than their historical counterparts.

Conclusion

No value multiple is superior to the other; each multiple has its own advantages and limitations. The analyst must study the subject company carefully and then choose the most appropriate valuation multiple/multiples for performing a valuation. Should we use just one single multiple for valuing the subject company or more than one multiple and finalize the value based on a weighted average of values implied by each multiple? Share your thoughts.

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