Valuation multiples have a firm and detailed analytical basis underlying the basic calculations most investors like to throw around when discussing relative entity value. I could take you through the hard core, and surprisingly complex, mathematics responsible for generating various multiples – but then I would bore you to tears and miss instilling a basic guideline that is likely all nearly anyone needs to understand to have a competent understanding of what determines the size of multiples. Whether it’s a multiple of EBIT, EBITDA, Earnings or any of the numerous other valuation multiples commonly used to compare the relative value of companies, understanding the following will allow you to confidently understand and challenge any discussion of value that may be underway in your organization.
Simply put, the higher the perceived growth of a company, and the lower the capital intensity of the company and its related sources of growth, the higher the valuation multiples a company will earn. Conversely, a slow growth company that basically grows with GDP and has a high degree of capital intensity and need for replacement capital will likely be assigned lower valuation multiples. Remember, growth in this guideline is a consensus perception, and this perception can change with something as simple as a minor news release or poor economic indicator.
However, there is one major exception to this guideline that should be considered when dealing with asset intensive companies. The guideline assumes the underlying book values of a company’s assets are being accurately reflected by the required accounting treatment of those assets (i.e. the book depreciation of a company’s primary assets fairly reflect the decline in the market value of the assets). However, in some industries, the correct accounting treatments of certain assets require the depreciation of assets that are actually maintaining value or appreciating in value. In such cases, higher multiples are likely as a result of the hidden underlying value being captured in the entity. Another way to look at it, the market is acknowledging that depreciation is a phantom expense and should be added back to earnings.
The guideline will basically explain why a capital intensive commercial transportation company like JB Hunt will generate significantly lower normalized valuation multiples than a higher growth and lower capital intensive service oriented commercial transportation company like CH Robinson.
Hey Dan….Really nice article…
I agree with the facts which you mentioned, however, what i think is that there is always the chances of Valuation getting wrong because its a subjective thing…You have to be reasonable in the valuation and defend your valuation based on atleast 2-3 strong view points…Every different analyst has different point of view…
Obviously nullfying the extra ordinary point of the comparables need to be considered and consideration of directly average multiple of the peers does not make sense, as you mentioned, but again that thing will be subjective as well…
Taking for an example of say an XYZ Company, which is private, and i have peer comparable companies such as eBay, and Amazon, but i cannot directly consider the average multiples of them, my subject company is a significant smaller than eBay and Amazon. Hence i have to make an adjustment for an higher growth and smaller traction in revenues, and smaller size for my subject company in order to compare it to the peer companies. However, it still is an subjective adjustment. I am pretty sure, 70% to 80% of the M&A transactions will never get acquired at the similar or atleast the closer multiple when compared to some valuation done in the recent timing for the acquired entity, but if the multiple is within the valuation range of may be 10% to 20% than the overall valuation makes sense…
Every comparable company is something different in it self…comparable companies differ based on the size, product portfolio, business model, revenue traction, stage of development, and funding. However, with respect to the valuation there is a factor always attached is called subjectivity…In valuation industry everything is considered as “It depends” there is no proper answer for majority of the things…
With respect to the DCF analysis, i too agree that majority of the time the projections and other important factors like Cost of Capital & Capital expenditure & Working capital on which the DCF valuation is based were not reasonable… See this article its interesting in terms of the considering COC for the DCF … http://www.ericnath.com/articles/TheBigMyth.pdf