Valuation multiples, such as the price-to-earnings ratio and EBITDA multiples, are useful financial metrics to estimate a company’s value based on relevant peers. In the case of the price-to-earnings ratio the result is equity value, whereas EBITDA multiples determine enterprise value.
It is important to note, however, that valuation multiples do not occur in a vacuum. They represent the inverse of capitalization rates, which in turn, reflect investors’ expectations of return on their investments. Another important point to consider is that valuation multiples are dynamic as they tend to vary by year, industry and company. Thus, to gain a perspective into what is really driving valuation multiples, one must dissect them into their constituent parts.
In general, valuation multiples are driven by three factors: risk, growth and leverage. Each of these elements exerts its own unique influence on the valuation multiple’s final outcome. For one, there is the well established principle of the correlation between risk and return. Risk in this context means the potential for the variability of returns based on possible changes in the company’s operating performance. A common proxy for this type of risk is company size. Thus, it follows that the smaller the company, the higher the perceived risk, the higher the associated expected return an investor will see and, consequently, the smaller the associated valuation multiple.
The second factor influencing valuation multiples is the expected growth in a company’s cash flows. This growth results from a combination of the realization of synergies and the implementation of competitive advantages. All other things equal, the higher the prospective growth in cash flows, the higher the multiple an investor is willing to pay for the investment.
Lastly, there is the element of leverage. An investor’s ultimate goal is to realize an expected return on investment. And, it comes to reason that the lower the investor’s cost of capital, the higher the potential to realize an expected return. One of the simplest ways to lower the overall cost of capital is by using leverage. Equity is the most expensive form of capital so adding debt decreases the weighted average cost of capital for the investor. There are limits, of course, to how much leverage can be used before encountering adverse effects. But, the conscientious use of leverage will decrease the investor’s cost of capital and help boost return on equity.
In sum, valuation multiples such as EBITDA multiples are widely used in M&A. But, as previously described, these multiples have distinct component which influence their magnitude and behavior. For professional advisors, knowledge of these components provides useful market, industry and company insights. Keep this in mind the next time you see a report stating that the median EBITDA multiple in the middle market last year was 6.5x. There is a great deal of information behind this single metric.
About Enrique Brito
Enrique Brito is a senior financial executive and a principal at Kaizen Consulting Group. He is a national instructor and lecturer on M&A, business valuation and negotiation topics. Learn more about him here and connect with him on Twitter.
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On Value 