Valuation multiples: key metrics for assessing business value

Valuation multiples are powerful tools for comparing a company’s value to its operational performance. They provide quick and intuitive ways to benchmark companies and assess their relative value. However, selecting the right multiple is crucial. The chosen multiple should emphasize the aspect of the business you want to evaluate, and it is essential to maintain consistency in how the multiples are applied.

For example, a company can be valued using Enterprise Value (EV) or Equity Value (EqV). The difference lies in the metric being used alongside the multiple:

When using EV, the chosen metric must be independent of the capital structure (e.g., before interest expenses). Conversely, when using EqV, the metric must depend on the capital structure (e.g., after interest expenses).

Most common multiples

Here are some of the most widely used multiples and their practical applications:

EV/Sales:

• Ideal for companies that are not yet profitable, such as startups.
• This multiple focuses on top-line performance and is particularly useful for early-stage businesses.

EV/EBITDA:

• One of the most comparable multiples because EBITDA is a strong proxy for cash flow.
• This multiple highlights a company’s operational efficiency and ability to generate cash.

EV/EBIT:

• Useful for measuring operational profitability while considering depreciation and amortization costs.

NI/Equity (ROE):

• This multiple evaluates the return on equity, providing insights into how effectively a company generates profit from its shareholders’ investments.

P/E Ratio (Price-to-Earnings):

• Popular among equity investors, it measures how much investors are willing to pay per dollar of earnings.
• However, this ratio is highly dependent on the company’s capital structure and may vary significantly across sectors.

Additional multiples for debt and investor insights

Net Debt/EBITDA:

• This multiple helps assess a company’s leverage and financial health
• A ratio below 2 indicates a manageable debt level.
• Companies with a low Net Debt/EBITDA ratio often have the capacity to take on more debt to fuel growth or acquisitions.

Dividend-related ratios:

For equity investors, dividend-related multiples offer important insights into a company’s profitability and shareholder returns:

Dividend Yield = Dividends / Equity

Measures the return on investment for shareholders based on dividend payouts.

Payout Ratio = Dividends / Net Income

Indicates how much of the company’s earnings are being distributed as dividends.

Zoom on the price-to-earnings (P/E) Ratio

The P/E Ratio is one of the most recognized multiples:

Formula: P/E = Share Price / Net Earnings (EPS) = P/E = Market Capitalization / Net Income

Interpretation:

A P/E ratio of 17 implies that purchasing all of the company’s shares would cost 17 years’ worth of its net earnings.

• P/E < 10: Considered low, potentially undervalued.

• P/E between 10 and 20: Average range for many sectors.

• P/E > 20: Considered high, often justified by strong growth potential.

Classic case study:

If Company A has a P/E ratio of 14 and acquires Company B with a P/E ratio of 9 in a 100% stock deal:

• The transaction will likely be accretive because A’s P/E is higher than B’s.
• Accretive deals increase the acquiring company’s EPS, whereas dilutive deals reduce it.

Key considerations: post-multiples adjustments

Once multiples are calculated, discounts are often applied to adjust the valuation for specific risks or characteristics:

Size discount: Smaller companies carry higher risks due to less diversification and lower market influence

Liquidity discount: reflects the lack of marketability for shares in privately held companies or low-trading stocks.

Risk discount: accounts for higher operational or financial risks faced by the business. 

Lack of control discount: commonly applied when valuing minority interests, as these shares lack decision-making power.

The strategic role of multiples

Valuation multiples are not just numbers; they serve as a lens to understand the company’s financial health, market position, and growth potential. For instance, EV-based multiples are widely used in M&A due to their independence from capital structure, making them ideal for comparing companies with different financing strategies. Equity-based multiples like P/E or ROE are more relevant for equity investors who focus on shareholder returns.

The strategic use of these multiples helps identify undervalued companies, assess acquisition opportunities, and justify valuations during negotiations.

Thus, valuation multiples are indispensable for analysts, investors, and corporate decision-makers. By combining key multiples such as EV/EBITDA, Net Debt/EBITDA, and P/E, along with appropriate adjustments for risks and market conditions, businesses can derive robust insights into their value. However, multiples are only as reliable as the context in which they are used. Analysts must consider the industry, growth potential, and market conditions to ensure meaningful and accurate comparisons.

Understanding and applying these valuation multiples effectively can provide a significant edge in today’s competitive financial landscape.