Perhaps nothing in valuation theory is less understood and more manipulated than the wide arrange of valuation multiples used to measure value and extrapolate value onto supposedly comparable opportunities. It has often been pointed out that a stock chart can be created on an individual security or index to support the creator’s argument simply by carefully choosing the start and end date. Creating value arguments on a target opportunity based on the average of a supposed basket of comparable companies is also an easily manipulated analysis. Often used by those with a vested interest in swaying the decision making process in a direction most advantageous to themselves, reliance on multiples to provide even a top level indicator of value should be used judiciously during all phases of the valuation process.
As was discussed in a previous blog covering the primary drivers of all multiples, perceived revenue growth and capital intensity are the dominant drivers of the most often analyzed valuation multiples. High growth, low capital intensity companies have relatively high valuation multiples, slow growth and highly capital intensive companies have relatively low multiples. All multiples are a reflection of a specific company’s perceived free cash flow generating capability.
Therefore, when attempting to determine an approximate value for a specific business enterprise based on a comparable entity, the analysis would not provide a reliable indicator of value unless the comparable is a nearly identical entity. Taking the issue a step further, multiples are often based on a basket of casually comparable companies. Further, each company in the basket usually contains a variety of business platforms with varying growth and capital requirements.
So let’s discuss how in the real world multiples as an indicator of value can get out of control and maybe even take a life of their own. To anyone who has been involved in the senior ranks of any corporate entity considering an acquisition or divestiture strategy, the typical early phase of the project will sound quite familiar. A series of investment bankers or financial advisors are invited to present their qualifications to represent the organization. Almost certainly an analysis is presented containing the multiples of a basket of companies which the advisors selected as being comparable. The average multiple is referenced and often becomes the unofficial benchmark of the bid and valuation process.
Whether or not the multiple is a true indication of the value of the target opportunity, it surfaces as a reference point throughout the process. In the case of the bidding and valuation segment of an acquisition review, typically a value close to the average multiple is used as both the purchase price and terminal value – let’s face it, no one assumes they sell a business for less than they purchased it. Now a multiyear cash flow analysis is created showing retention of nearly all of the target’s base revenue, growth of the base revenue, and cost efficiencies through a myriad of potentially justifying assumptions. Guess what, the valuation is going to show a return on the transaction that is exceptional. However, if the target multiple is a poor reflection of the attributes of the acquisition candidate, even a flawless execution of the integration and management of the acquired entity can still result in an economic disaster.
Now let’s look at an example of how flawed multiples are as indication of value as it relates to a specific industry. For well over a decade I managed the Corporate Development department of a major commercial transportation company. The largest division was primarily engaged in truck leasing and rental. The industry’s growth was fairly consistent with GDP growth and the competitive landscape was made up of two major competitors and approximately a 100 small to mid-size leasing companies. Acquiring a regional was always an attractive strategy to capture spurts in revenue growth and consolidation cost efficiencies.
There were numerous factors determining the value of each specific target entity (revenue mix, customer base credit quality, maintenance facility locations and quality, etc.). However, to prove how flawed multiples are for determining value, I will present an example of two identical leasing companies with the exception of just one operational attribute:
Consider two identical leasing companies with a fleet of a 1,000 vehicles maintained out of 9 facilities and growing approximately 3%-5% annually. Both companies generate revenue of $22m, EBITDA of $7m and EBIT of $3m. Now let’s give them just one distinguishing characteristic: average fleet age. Assume the average fleet age of one of the companies is 12-18 months and the other is 55-60 months.
To determine the multiple value of the two entities let’s assume the long term historical EBITDA and EBIT multiples of public leasing and rental companies is 5x and 13x, respectively (remember, slow growth, high capital intensive businesses will likely have low multiples). Using multiples to determine the enterprise value of the two companies will result in an indicated value for both companies of somewhere between $35m – $40m.
However, I can assure you, purchasing both of these companies at this purchase price range will result in significantly different economic returns. The newer fleet transaction will likely result in an attractive return, low overall risk and a relatively small amount of goodwill. The older fleet transaction will likely have the opposite results – substantial goodwill, high loss business risk and negative economic returns.
I could go through a dozen reasons why just one operational attribute can expose the substantial flaws of using any multiple as a legitimate indicator of value, so you can imagine how inadequate they are in the real world where dozens, if not hundreds, of key attributes differentiate company values.
As a final note I would like to share an experience I had in my past life of managing the Corporate Development department of that company with a large truck leasing operation. During that time period I was constantly asked by investment bankers, brokers and numerous owners of regional truck leasing companies what was the target multiple we used when reviewing acquisition candidates. My answer was always the same – we did not use multiples because they were not a valid indicator of value.
I received all types of replies to this statement. Some just gave me dirty looks, others thought I was just protecting a highly confidential piece of information, one company owner told me he was certain I received a sliding bonus based on how far below the target multiple I was able to purchase companies. None believed I was telling the truth, especially the bankers and brokers. People like simple calculations for what should be an extensive analytical, strategic and operational process. It’s this simplicity of using multiples to determine value that is partially responsible for what can result in a highly political transaction review process – but that’s a story for a different blog.
So what’s the bottom line? Do you need to know what the multiples are for the industries you are targeting for a transaction? Yes. Should you consider the multiple to be an even remotely adequate indicator of value? Never. And I mean NEVER. What is more important is that you master an understanding of what operational and financial attributes are driving the multiples in the industry you are targeting. If you can find three or more reasonable comps for your target industry, understanding the drivers of what is causing the difference in multiples is far more valuable than knowing the average multiples of your basket of comps.
