Similarly sized and spec’d houses in the same neighbourhood should have similar asking prices, should they not? The multiples approach is a theory of valuation based on this same concept: that similar assets sell at similar prices. It assumes that a ratio comparing value to a firm-specific variable, like operating margins or cash flow, is the same across similar firms. The most common market approach makes use of the prices at which comparable public companies are trading, relative to their earnings, to imply comparable valuation multiples (these are often referred to as “Price-to-Earnings” or “P/E” ratios).
For the smaller privately-owned companies it serves, EquityMaven uses Enterprise Value relative to earnings before interest, tax, depreciation and amortization (EBITDA) (“EV/EBITDA“ or sometimes, for short, just “EBITDA” multiples) for comparable companies to perform its valuation calculations. These EV/EBITDA multiples are applied to the Sustainable EBITDA of the company being valued, in order to derive a business valuation. We do this because:
- This valuation methodology is well understood by the public and relies on the market ratings of comparable companies, which have similar business activities and risks.
- We use the market approach as the secondary methodology to back up the findings of the primary income approach.
- Differences in valuation between the DCF and EV/EBITDA valuations will most likely be attributed to differences in forecast cash flow growth rates between the company being valued and the industry comparable companies used in the EV/EBITDA valuation.
Here’s a worked example to explain the EV/EBITDA multiple valuation approach:
- The first step is to calculate the sustainable EBITDA for the last twelve months for the company being valued. Assume this is $20,000 for the purposes of this example.
- Sustainable EBITDA is the EBITDA after subtracting any earnings and adding back any expenses that are once-off in nature. Going forward, this will give a more “normalised” picture of what the company EBITDA is expected to be.
- Next, an appropriate valuation multiple must be applied to the Sustainable EBITDA to result in an Enterprise Value for the company being valued.
- An appropriate valuation multiple is calculated by looking at other firms that are comparable to the company being valued and that are listed on public stock exchanges (and/or other known private transactions). The comparable company Enterprise Values are divided by their respective EBITDAs over the last 12-month period to arrive at EV/EBITDA ratios (or “multiples”) for each comparable company.
- A median of these comparable EV/EBITDA ratios is then calculated and applied to the trailing twelve-month sustainable EBITDA of the company being valued, to result in the Enterprise Value.
- Excess cash is then added, and interest-bearing debt subtracted from the Enterprise Value to calculate the Equity Value.
- An illiquidity discount is then applied if the company is privately held.
It’s important to note that this type of EV/EBITDA multiple valuation can only be performed if the EBITDA for the company being valued is positive. Here are the workings:
Because it relies on trailing 12-month data, and existing EV/EBITDA multiples data – and because they do not rely on detailed financial forecasts which can take owners (or management teams) a lot of time to complete – valuations performed in this manner can often be done faster than the more technical DCF approach. For this reason, EquityMaven uses the EV/EBITDA multiple valuation approach as a robust and well-understood secondary methodology.