Unraveling the Mysteries of Valuation Multiples by Industry (2024)

FAQs

What are the problems with multiples valuation? ›

Meanwhile, using multiple analysis can also lead to difficulty in comparing companies or assets. This is because companies, even when they seem to have identical business operations, may have different accounting policies. As such, multiples may be easily misinterpreted, and comparisons are not as conclusive.

EBITDA multiples also don't consider future working capital needs or trends that may affect future cash flow. In addition, depreciation expense may not reflect the amount that the company needs to spend on annual capital expenditures.

Operating profit + Depreciation + Amortization = EBITDA

Typically, industries with higher potential for future growth will have higher multiple values, and larger, more established companies will have higher multiples than smaller ones. The level of EBITDA itself will also play a role in assigning multiples.

However, multiples also have some limitations and challenges. First, finding truly comparable companies or assets can be difficult, especially for unique or niche businesses. Second, multiples can be affected by accounting differences, such as depreciation methods, inventory valuation, or revenue recognition.

The disadvantages of using multiples are that they can be misleading, inconsistent, and subjective. You may not find truly comparable companies, or you may have to adjust for different accounting practices, growth rates, risk profiles, and capital structures.

Insensitivity to Debt Levels:** EBITDA does not consider interest payments, which can lead to an overestimated valuation for heavily leveraged companies.

Some experts consider EBITDA to be a useless metric because it does not take into account the company's debt expenses. EBITDA measures a company's performance before factoring in how it's financed, so using this metric alone may provide a less than complete view of the business.

That is because the EBITDA margins are calculated net of interest costs. But in case of banks, the interest cost is actually the operating cost. That is because banks actually thrive on the spread between the yield on funds and the cost of funds.

Various industries generally have different EBITDA multiples because different industries have different growth prospects, financial performance, and financial metrics.

What drives higher valuation multiples? ›

The higher the risk, the lower the value multiple, because an investor is willing to pay less for the investment in order to ensure a higher ultimate return. The lower the risk, the higher the value multiple, because the investor is willing to take a lower return.

The most common multiple used in the valuation of stocks is the price-to-earnings (P/E) multiple. Enterprise value (EV) is a popular performance metric used to calculate different types of multiples, such as the EV to earnings before interest and taxes (EBIT) multiple and the EV to sales multiple.

Advantages and Disadvantages of Multiples in Valuation

It takes a known quantity for a firm like earnings or book value and converts it into a proposed price for the firm. The problems associated with multiples are many, starting with the difficulty in finding comparable and timely comparisons.

It is commonly used when selling and buying businesses, as it helps establish a fair market value for the company being sold or bought. Generally speaking, businesses sell for between three and six times their EBITDA (earnings before interest, taxes, depreciation, and amortization).

The P/E ratio does not take into account a company's debt levels. A company with a high debt-to-equity ratio may have a low P/E ratio, but it could also be a sign of financial distress. Conversely, a company with low debt levels may have a high P/E ratio, but it could also be a sign of financial strength.

The multiples valuation method is based on several assumptions that should be recognized and evaluated, such as the market being efficient and reflecting the intrinsic value of entities, comparables being similar to the target company in all relevant aspects, multiples being consistent and comparable across entities, ...

Valuation issues can range from asset/collateral matters, to disputes as to the true value of a business as a whole entity, to fairness issues related to the valuation of securities and cash flow streams being proposed to settle the claims of various stakeholders.

For an investment banker or someone trying to sell a business, high multiples are great because they provide a basis for pricing a business at a premium. For investors, lower multiples are a great filter used to find assets that might be undervalued.