What’s Your Worth? A Look into Valuation Multiples (2024)

Have you ever read an article in the Wall Street Journal about a company that just wentpublic and thought to yourself: “How isthatcompanyworththatmuch?” Or, have you ever wrapped up a hard quarter andwondered: “Did all this effort actually make my business more valuable?”

For owners and senior managers of small and midsize businesses, these are not idle questions.If you’re considering a capital infusion to fund growth, or an acquisition toaccelerate it,you want to know how the market arrived at thoseother company valuations so you can use the same technique to determine what yourbusiness—or your acquisition target—is really worth.

The good news is there’s a fast-and-simple financial analysis—valuationmultiples—that canhelp. All you need is some basic math, which we’ll get to in a minute, along with theapplication of straightforwardvaluation principles.

At least you’ll know how the market arrived at that valuation, even if youdon’tagree with it.

Key Takeaways:

  • Valuation multiples represent the ratio of one business metric to the estimated valueor, for public companies, market value of a business.
  • Benchmark multiples from different industries can be used to estimate anybusiness’svalue, as long as you know the business’s metrics.
  • Most commonly used multiples are related to a company’s sales, earnings or assets.
  • It’s important to choose the right multiple to get a good valuation estimate andto makesure the benchmark you use is based on companies very similar to the one you’revaluing.

What Are Valuation Multiples?

The concept behind valuation multiples is that the market value of a business can becalculated based on the ratio of one or more key business metricsto the known values of companies similar to the one you’re valuing. While businessleaderspoint out that no single metric completely reflects the totality of a business, there aremany such metrics that businesses can incorporate into a valuation multiples analysis. Someare more applicable in one industry, or one type of company, than another. Calculatingseveral of these different ratios can give you a strong directional sense of abusiness’svalue.

Valuation Multiples Explained

The first thing you need to know to use valuation multiples is a little basic math. Thenumerator of the fractions involved in valuation multiples is always a business value. Anexample is the share price in the best-known multiple of all, the price-to-earnings (PE)ratio, which is simply the ratio of the company’s earnings per share (EPS) to itsshareprice.

Valuation Multiples Formula

The denominator is the business metric you’re focusing on for a givenanalysis—the earningsin a PE ratio. You transform that PE ratio into a “multiple” you can use invaluationanalyses by multiplying both sides of that simple equation by the business metric to getthis new equation: Business Value = Business Metric x the Multiple.

Numerator /Denominator = Ratio = Business Value / Business Metric = Multiple

Let’s do the math with a real-life example. On June 30, 2020,CharlesSchwab shares closed at $33.56, and its EPS was $2.38, for a PE ratio of 14.10. If you putthose numbers into the equation above, it looks like this:

$33.56 = $2.38 x 14.10

Schwab had 1.29 billion shares outstanding in September 2020, so itstotal valuation—that is, market capitalization—was $33.56 x 1.29 billion, or$43.3 billion.

Applying Valuation Multiple to Decisions

Valuation analysis isn’t a one to one comparison, so to estimate the valuation youwouldcalculate a given multiple for several similar business and find the median or mean valuefor all of those companies. Then compare that value to the same multiple for a givenbusiness.

Business metrics like the PE ratio are published for public companies across all industries.Sometimes the metric can be one number from a financial statement, for example, revenue, orEBITDA, and sometimes it’s also a calculated number, like a growth rate. Regardless,onceyou know a metric for a company you’re interested in, you can look up the benchmarkratiosof that metric to company valuations for that industry and multiply the ratio times themetric to arrive at an estimated value for the business.

Owners of small or midsize private companies can get a beginning estimate of theircompany’svaluation by multiplying one or more of their metrics times the appropriate publicly knownbenchmark ratio.

What Are the Different Types of Valuation Multiples?

There are different types of valuation multiples simply because there are different ways youcan calculate value. For example, if the company is publicly traded, you can look at itsstock price times the number of shares available, which equals its market cap. However, that ignores criticalinformation, like the amount of cash and debt on the company’s balance sheet.That’s whereknowing a company’s enterprise value is handy.

Sometimes, though, the value is just a number that has been set by independent financialexperts with insights into the market. This is particularly useful for private companiesthat don’t constantly have Wall Street valuing their business all day, every day, whenthestock market is open. The two examples below illustrate this well.

Example: Valuing a High-Growth Startup

As high-growth startups raise late-stage venture capital, you can often go back and see whatthe startup was valued at before it received funding, then track its multiples throughsubsequent funding rounds. At every single round, the company sells a fraction of itself, sodepending on what it raises, you have a new value for the company at each round. Say thecompany is selling 5% of its business, and an investor is willing to pay $20 million. Thatyields a $400 million valuation: $20 million / 0.05 = $400 million.

Investors can use this data to project valuations for similar businesses.

One popular example for software as a service (SaaS)businesses comes from lender SaaS Capital. The firm regularly updates its SaaS CapitalIndex to look at the average current revenue run-rate multiple relative to a cohortof public company SaaS valuations. “Run rate” refers to the practice ofextrapolatingcurrent financial results to predict future values.

The most recent update shows valuation equal to a median multiple of 14.7 times run-raterevenue. As the chart below shows, this valuation multiple has evolved over time.

In Q1, SaaS Capital proposed a 28% discount for valuing privateinstead of public companies. If you apply that 28% discount to the 14.7 multiple, you end upwith a 10.6 multiple:

14.7x – (28% of14.7) = 10.6x

Using this approach, a private SaaS business with a $10 million revenuerun-rate would be worth $106 million, based on this multiple.

One note of caution: It’s really important to make sure comparisons are accurate.Unfortunately, many entrepreneurs are overly optimistic when thinking about what the“right”comparable companies are for their businesses, or they don’t dig in to see where thecompcompanies’ revenue is coming from. Going back to our SaaS example with the $10 millionrun-rate, if some of that revenue was not recurring SaaS revenue, for example, then youshouldn’t apply the same multiple to that nonrecurring portion of revenue.

Example: Valuing Comparable M&A Transactions

Sometimes the measure of value is what another acquirer paid for asimilar business. This data allows a company’s board toprojectwhat the business would be worth if approached by similar buyers. Two notes of caution:

  • First, not all buyers are going to value a business the same way. As anoversimplification, financial buyers seeking an investment will pay less than acquirerswho are looking to buy a business for strategic purposes, such as a manufacturer lookingto fill in a gap in its product line or a retailer reaching a different demographic.
  • Second, keep in mind that often, beyond the metrics, there can be other considerationsfactoring into any given acquisition valuation—so if you pick the wrong metric tofocuson, all you get is noise.

Different Types of Business Metrics

This leads to the more important decision for business leaders focused on leveragingvaluation multiples: which type of business metrics to focus on. While some industries havevery specific business metrics that are most relevant, in general, picking the right metrictypically comes down to three choices.

Choice 1: Valuing Revenue vs Profit

Most leaders need to decide if they should focus more on revenue or profitability. Ingeneral, companies earlier in their development prioritize top-line revenue, while moremature businesses focus on profit and unit margins. There are certainly exceptions to thisrule. A well-cited example is Amazon.com, which has relatively low profits compared torevenue, but has grown into one of the most valuable companies in the world primarily basedon revenue—or, more specifically, revenue growth rate.

If a company is being valued based on revenue, it’s important that there is a crediblenarrative about how it will—eventually—become profitable. This is where the gross margins for specificproducts become important, because this data can be used as the metric in valuationmultiples analyses.

Even if the company is investing that gross margin back into the business to furtheraccelerate growth, it’s important that a company’s products or services havedecent gross margins as it starts to scale. Otherwise, the firm may end up in asituation many growth equity firms describe as “profitless prosperity.”

Choice 2: Valuing Historical Results vs Forecasts

Another important consideration: Are you using historical results or forecasts? There areadvantages and disadvantages to both approaches. Historical results are, by definition, muchmore precise and accurate. They also ensure that, if you are comparing different companies'results, you don’t have varying “levels of optimism” baked into thenumbers, as can happenwith financial forecasts.

However, given that the value of a company is fundamentally much more about future profitsthan it is about the current or past state of the business, if forecasts can be doneaccurately and both sides can agree on the conclusions, they’re generally morehelpful.

Choice 3: Current Results vs Growth Rate

The debate between historical results and forecasts also leads to a related point: In somecases, it becomes difficult to agree on which forecast to use. However, in situations wherethe past can credibly be argued as directionally predictive of the future, one helpfulapproach is to use the company’s growth rate. Growth rate is typically usedin combination with current results.

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Common Formulas for Calculating Valuation Multiples

Now that we’ve walked through these conceptual choices, here’s a set of commonformulas usedto calculate valuation multiples based on either a company’s revenue or its profit.

Revenue-based formulas: If you want to focus on revenue, the two mostcommon formulas you’ll hear about are “EV to Revenue” and “Price toSales.” In both of thesecases, you’re focused on top-line revenue, not profit. The big difference is whetheryou usethe company's market cap (price) or enterprise value (EV). You’ll sometimes hear thesereferred to as “EV to Sales” or “Price to Revenue.” In other words,sales and revenue aresynonymous.

Profit-based formulas: Alternatively, profit, or what is typically describedin these ratios as “earnings,” are the area of emphasis. Similar to above,profit-basedmultiples formulas can also focus on market cap (price) or EV. One common example,“Price toEPS,” focuses on earnings per share, and is simply share price divided by EPS. In thiscase,because earnings are being divided by the number of outstanding shares, you can use shareprice instead of market cap in the numerator as the measure of value. This is the exact samething as taking market cap and dividing it by total company earnings.

A company’s growth history is one metric that will influence its value. For example, acompany that’s consistently growing at 10% a year might justify a higher valuationthan acompany with similar earnings that’s growing at 4%. You’ll often hear analyststalk about acompany’s “PEG ratio,” which stands for a company’sprice-to-earnings growth rate. A PEGratio is calculated as PE ratio in the numerator and EPS growth — typically over onetothree years — in the denominator.

There also are valuation multiples that focus on different ways profit or earnings can becalculated. Sometimes it’s helpful to look at EBITDA (earnings before interest, taxes,depreciation and amortization). You’ll often hear analysts talk about acompany’s EV toEBITDA ratio.

How to Use Valuation Multiples to Compare Companies

Books have been written and MBA courses offered on this topic. But here are a few things tokeep in mind when comparing companies using valuation multiples:

  1. Make sure you’re calculating the multiple the same across companies. For example,if onecompany’s analysis uses forward-looking projections and the second uses historicaldata,you won’t be able to draw any reasonable conclusions. Similarly, if one valuationmultiple is using EBITDA for earnings, make sure the other is as well.
  2. Whenever possible, evaluate companies using a variety of multiples. The common formulasdescribed above drive at different business principles. If the companies are actuallycomparable—for example, they’re in the same industry—then it’shelpful to compare acrossa few multiples.

If your company is seeking funding, ensure you have a handle on yourvalue and can discuss the method by which you determined that number, how well youmet previous projections and why your forward-looking revenue scenarios are solid.

Why Are Valuation Multiples Different for Different Industries?

First of all, different industries have different profit margins and operating models. As aneasy example, manufacturing firms and software companies typically have very differentmargins. Therefore, a multiple focused on top-line revenue is not that helpful whencomparing companies across those two industries.

Different markets also have different growth rates. And sometimes, growth rates can get verygranular. For example, most retail industry analysts forecast different growth rates forin-store commerce vs ecommerce. Therefore, different multiples for different retailers arecommon. Obviously, individual sectors within retail may also have different growthforecasts.

Why Do Valuation Multiples Matter for Your Business?

Valuation multiples can give you a sense of how similar businesses compare in value. This canhelp your team understand a number of things, including:

  1. What is our business currently worth?
  2. What adjustments can we make to increase its value?
  3. What is a fair price for another business?
  4. How do current valuations relate to historical periods?

It’s important to choose the right multiple to get a good valuation estimate and tomake surethe benchmark you use is based on companies very similar to the one you’re valuing.

What’s Your Worth? A Look into Valuation Multiples (2024)
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