Principles Valuation methods which are based on multiples of projected financial data are easily applied in theory. The guiding principle is that multiplying projected financial data which are directly or indirectly related to the future profitability of the company, by a number which is the multiple by which similar public companies are traded, or according to which similar private companies have raised capital, provides a scale for valuating the assessed company. The method identifies a set of companies that is comparable on various dimensions, such as area of operation, the maturity of the company, and its size. It looks at the set of appropriate variables for comparison and then compares the ratios of market valuation to these variables. The ratios are then applied to the parameter values of the valued company. The best-known multiple is, of course, the earnings multiple (namely, the ratio between the price of a share and the earnings it yields, otherwise known as the price/earnings, or P/E, ratio). For example, assuming that Speed, Inc. generates current annual earnings of $10 million, and that similar companies are traded on the stock exchange according to an earnings multiple of 40, then the value of Speed Inc. (without taking into account other data) is $400 million. Analysis based on multiples typically relies on the peer group's current results and forecasts made by market participants such as equity research analysts. However, it is important to understand that valuation based on multiples is meaningless if the variables used for comparison do not reflect the ability of a company to create value for its shareholders. In market sectors that have little history, selecting appropriate parameters is difficult and market participants tend to change from time to time their perspectives on such multiples. As a result, many investors use parameters that seem to explain the market valuation of other companies in the sector, sometimes with disregard to their economic link to future profitability. In most cases, therefore, we do not prescribe multiples as a central mechanism for valuation. Regardless of the explanatory power of a multiple for pricing at a specific time, unless the multiples are logically and economically related to the future profitability of the company or to the way potential buyers of the company value it, they are meaningless. History shows that periods of incorrect valuation can last for a long time and naturally lead to opportunistic behavior by companies. For example, in many industries, such as the construction business, companies are valued by future revenue multiples. That may give companies incentives to sign money-losing contracts before trying to raise capital, even at the expense of future profits. Supplementary information on the financial stability and the prospects of a company can be derived from balance sheet multiples, such as enterprise value-to-total assets, or equity market value-to-equity (market-to-book ratio). These ratios are highly relevant in mature industries. However, in growth industries relying mainly on intellectual capital, they may distort analysis unless the asset base or equity is adjusted for the pitfalls of some accounting rules. For example, the value of intangible assets, which may have been written off, may make these ratios seem out of context. In practice, the method requires the careful identification of companies whose business resembles that of the valuated company as closely as possible, determining an appropriate operating multiple for the valuated company, and multiplying it by the company's projected operating data. It is also important to remember that the operating data used for the valuation must be genuinely and logically related to the company's future profitability and hence to the earning or cash flows it will generate. The main advantage of the multiple method is the fact that it is based on market data, i.e., the company is assessed according to the value of similar companies. Obviously, this is also the main disadvantage of the method: In times of economic euphoria, the valuation of companies may include parameters which are not likely to be sustainable for long. For this reason, many investors are skeptical about valuations made in times of booming stock markets on the basis of projected operating multiples. Determining the group of comparable companies When making valuations on the basis of multiples, the multiple has to be determined in accordance with a profile of companies which is as similar as possible to the valuated company. When looking for companies to provide a comparison, the selection process is crucial. Leading companies in an industry may receive a premium in the marketplace, reflecting the premium pricing they can charge or the increased profitability (due to economies of scale) they may achieve. In addition, the financial leverage and equity risk differences associated with factors such as the companies' cost structure could explain differences in multiples. It should also be kept in mind that the companies traded on the stock market are the successful companies in each field. In other words, there is a selection bias, and the operating profile of the representative group of companies is not necessarily similar to that of the valuated private company. Determining the relevant parameter and its values Once the group (or groups) of companies comparable to the valuated company has (or have) been chosen, the parameter for comparison, such as earnings or sales, must be selected. Several parameters should usually be chosen, rather than relying on a single variable. In addition, it should be determined whether current or projected data will be used. Most parameters, except for earnings per share and sales, are not predicted by market analysts. Therefore, only historical and current information is used and is compared to the predicted parameter values for the valued firm at a stage of maturity that is similar. In most cases, multiples should be based directly on profitability. This can be measured as the ratio of enterprise value (that is, the market value of equity plus debt) to EBIT (earning before interest and income taxes) and price to earnings per share; or operations, such as price to sales, whether these ratios are based on current or forecasted values. Other ratios may need to be used, typically where the industries under examination have not shown meaningful reported profitability because of their early stage of development. Large investment can also adversely affect reported profitability as well as lack of meaningful revenue (in which case measures based on revenue are meaningless as well). However, investors should be wary of measures that do not refer to the cost of obtaining future profitability, for example, ratios based on simple EBITDA (earning before interest, income taxes, depreciation, and amortization). Multiples that incorporate the cost of the capital and the required capital expenditures are useful in this context. Such adjusted mechanisms, which are based on current and forward-looking adjusted income measures, are applicable in most situations involving publicly traded and private companies. However, these measures are not always adequate by themselves in very early-stage industries where revenue is scarce, and should be used with other tools. It is hard to overrate the importance of choosing parameters which are highly correlated to profitability in the future. In other words, it is important that the parameters constitute a material gauge of the companies' future profitability. Also, when comparing firms on parameters that are not financial, it is crucial to understand the differences in the relevance of a parameter across firms. Allowing for the risk factor When performing valuations on the basis of multiples, it is important to make allowances for the specific risk factors of the comparable companies. Since the valuation of every company is based on the discounted financial flows of the company, it should always be kept in mind that companies will be traded according to different multiples in accordance with their projected flows, as well as the level of uncertainty (or riskiness) associated with these flows. Therefore, when determining the multiple, the relevant parameters of the peer companies should be carefully examined. Such parameters include profit margins, the rate of tax to which they are subject (which naturally affects the net future flows), and the degree to which debt is used to finance the company's activity. Multiple compositions The relevant parameters which are used as a basis for multiplication by the industry multiple are unique to each field. Therefore, the value of companies operating in several industries should be calculated based on a sum of the values of their business divisions, while applying the relevant industry multiple to each division. Customary Types of Multiples Net earnings multiple Using the companies' net earnings is the simplest. However, these data are affected more than many other parameters by the company's capital structure. Since this structure is almost always subject to change, this multiple reflects the company's operating results less effectively than some other multiples. Furthermore, the company's net earnings are affected to a large extent by one-time profits, which may be substantial in high tech companies (for instance, profits resulting from dilution due to investments made in held companies). In other words, it is important to establish that the earnings used as a basis for determining the multiple represent earnings that will recur in the future. EBIT-based multiple The logic underlying the use of multiples which are based on EBIT is that these earnings are less dependent on managerial decisions with respect to the company's capital structure and on the effect of taxation on its activity. Multiples which are based on this parameter are indeed better focused on the company's operating profitability and on the risk entailed in obtaining them, since they are less affected by the tax shield which the companies enjoy (factors not associated with the company's operating cash flow, such as the recognition of depreciation and interest expenditures for tax purposes, provide companies with a tax advantage or a tax "shield"). Book value-based multiples A market to book multiple reflecting the ratio of the company's market value to its net book value. In the most simplistic manner, the company's market value reflects the market value of all of the company's assets minus its liabilities, i.e., the amount which would be divided among the shareholders if the company were to dissolve after selling all of its assets and paying all of its debts. Most public companies are traded at a market to book value multiple which is much larger than 1. Even after revaluating the tangible assets of public companies in order to establish their market value, not their recorded cost, the ratio between the market value and the reappraised asset value is higher than 1. In practice, this phenomenon is explained by the value of the companies' intangible assets. These assets include the value of patents, managerial abilities, and brand value (goodwill). In the case of startups, the majority of whose assets are intangible and therefore are not reflected in the company's balance sheets, the method becomes meaningful only after many adjustments, such as capitalizing amounts invested in R&D, depreciating them over several years similarly to other tangible assets and multiplying them by a representative industry parameter. Other multiples Other common multiples are multiples of other operating data of companies, such as revenue multiples and multiples of the number of subscribers. In any case, the multiple method is meaningful only if the multiplied parameter is meaningful to the company's future earnings-generation ability. For instance, valuations based on the number of users of a software or other service which is given free of charge is meaningless if the number of users cannot be translated into future earnings ("monetized"), either in the way of revenues from subscribers, revenues from advertising, or other revenues. However, it is important to remember that a large user base could be meaningful to a strategic buyer even if it is meaningless to the company itself. For instance, when Microsoft acquired Hotmail, a company which provided free electronic mail services, the main motivation for the acquisition was to establish a user base for Microsoft's portal, which generates revenues from other services. Later on, Hotmail had also become a per-fee service for its advanced features. |
