Multiples

Types of Multiples
The multiples method represents a ‘quick and dirty’ approach to performing corporate
valuation. By benchmarking against peer companies, multiples are used to crosscheck
values obtained through fundamental valuation methods. Comparability is crucial if you
want multiples to be good indicators of value. For that reason, choosing the right type
of multiple is important. In this worksheet we will discuss various types of multiples
and their advantages and limitations to help you can make informed choices about which
multiple to use.

Earnings Multiples
Earnings multiples relate corporate value to a profitability metric. This type of multiple
is most commonly used in company valuation, because a company’s earnings are the
fundamental driver of long-term value. The drawback of earnings multiples is that they
can be sensitive to differences in accounting treatment and they can encourage earnings
management practices. This can make them susceptible to over- and undervaluation.
Furthermore, they cannot be applied to firms with negative (operational) earnings, while
high valuations may still be justified for these companies due to their future growth
opportunities.
Examples:

• P/E Ratio – computed as the share price divided by earnings per share. It is
the most widely used equity multiple and it indicates how high the price paid per
share is relative to how much profits are earned per share. The main limitation is
that the P/E ratio is affected by the capital structure, which limits its usefulness
when comparing companies with very different capital structures. Furthermore,
it includes non-operating items, such as restructuring charges or write-offs, which
are often one-off events and do not reflect business as usual. Lastly, the ratio
does not account for differences in growth rates between companies. Because of
these limitations, the P/E ratio is considered less useful as a measure for relative
comparison.

• EV/EBITDA – computed as enterprise value divided by earnings before interest,

tax, depreciation and amortization. This is the most commonly used enterprise
value multiple in company valuation by the financial community, as EBITDA is
often seen as a proxy for operational cash flows. It is often preferred over EBIT,
because EBIT is sensitive to the accounting method chosen for depreciation (i.e.
straight-line or double declining balance), and managers may be encouraged to play
around with depreciation to manipulate earnings.

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 By adding back depreciation you can normalize for this. The main disadvantage
of this multiple is that it does not account for the capital expenditures required to
maintain and grow a business, which are particularly relevant in capital intensive
industries. EBITDA multiples are popular among private equity investors, because
they often look at mature businesses with low required levels of capital expenditures.
• EV/EBIT – computed as enterprise value divided by earnings before interest and
tax. If you assume that capital expenditures are roughly equal to depreciation and
amortization (in that case a company can at least maintain its operations), then
EBIT may considered to be a better proxy for cash flows than EBITDA. However,
amortization is an accounting item that typically arises from previous acquisitions
and is not necessarily related to future cash flows; therefore, it is not a direct
value driver. By including amortization EV/EBIT multiples may lead to distorted
valuations and incorrect comparative conclusions.
• EV/EBITA – computed as enterprise value divided by earnings before interest, tax
and amortization. This multiple is sometimes considered superior to EV/EBITDA
and EV/EBIT, because you still account for capital expenditures by assuming they
are roughly equal to depreciation, but by adding back amortization you avoid the
distortions that might arise when linking value to items that do not directly drive
value.
• EV/EBITDAR – computed as enterprise value divided by earnings before inter-
est, tax, depreciation, amortization, and rental costs. This multiple is commonly
used for the valuation of companies in the hotel and transport sectors, because
their business models revolve around property ownership. Some companies in these
sectors own property while others lease it, but the two are treated differently from
an accounting perspective; in general, leasing requires rent to be expensed, while
ownership requires rent to be capitalized. In addition, owning or leasing property
leads to very different levels of depreciation, with ownership involving much higher
levels of depreciation relative to leasing. By using EBITDA and adding back rental
expenses, you therefore correct for the differences in accounting treatment and de-
preciation levels, allowing for better comparison between companies with different
ownership/leasing arrangements.

Sales Multiples
Sales multiples relate value to revenue. They can be useful when valuing companies with
(temporary) negative earnings, for instance, companies that are investing heavily (e.g.
early stage tech companies). However, the main drawback of these types of multiples is
that, by not taking profitability into account, they ignore a company’s efficiency. Ulti-
mately, if a company cannot convert sales into profits it will not be able to create value
in the long run. Furthermore, in order for a sales multiple to be an accurate comparative
metric, one must assume that the companies have similar operating margins, which is
rarely the case.
Examples:
• P/Sales – computed as share price divided by revenue per share, or alternatively,
as market capitalization divided by total revenue. This multiple is an indicator of
the equity value that is placed on each dollar of a company’s revenue.

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 • EV/Sales – computed as enterprise value divided by total revenue. It indicates how
much value a company generates from its sales, or from an investor’s perspective,
how much it costs to purchase a company’s sales. This type is preferred over the
P/Sales ratio, since the latter fails to take a company’s debt into account. The
enterprise value multiple is therefore more useful for comparing between companies
with different capital structures. In addition, the ratio is more internally consistent,
since it links the sales generated by the entire firm to the value that accrues to all
capital providers, not just the equity holders.

Market-to-Book Multiples
Market-to-Book multiples relate the market value of a company to its book value. These
types of multiples are often used when valuing companies with business models in which
assets play a critical role, for instance, when valuing financial institutions. Financial
institutions have completely different business models than other companies, involving
a different use of capital structure. Consider a bank as an example. Debt plays a
fundamentally different role for a bank: Its liabilities (mostly deposits) can be seen as
‘factors of production’ since they are used to create ‘products’, e.g. loans. These assets
in turn are a crucial driver of their earnings, through the so-called net interest margin.
Hence, a bank’s balance sheet is a crucial determinant of value. The main limitation of
this type of multiple is that it does not take return on equity into account. Even though
companies might have an excellent balance sheet, there is no guarantee that they also
have a great profitability profile. Furthermore, balance sheets are highly influenced by
accounting conventions, which limits the usefulness of these multiples when comparing
companies that are subject to different accounting regulations.
Examples:

• M/B Ratio – computed as market capitalization divided by book value of equity,

or on a per share basis, as share price divided by book value of equity per share. The
multiple reflects how much value the market ascribes to a company’s equity. This
type is preferred due to its simplicity and intuitive interpretation. A disadvantage
is that this multiple cannot be used when a firm’s book value of equity is negative,
which could be the case if it has experienced a long series of negative earnings or
in the event of a leveraged buyout with dividend recapitalization.

Industry Specific Multiples

Industry specific multiples relate the value of a company to a particular industry specific
metric. These are typically used when the value of a company is primarily driven by a
non-financial variable. For instance, online newspapers predominantly derive value from
the number of subscribers to their platform. Linking value to subscribers is more sensible
in that case. Industry specific multiples automatically take industry specific risks into
account, making them a better metric for comparative judgment. They are a means
to standardize across companies in the industry. However, a drawback of these types of
multiples is that they do not provide information about operating efficiency. If a company
is unable to convert the number of users into profits and cash flow, ultimately it will go
bankrupt and be worthless, making the multiple meaningless. Therefore, it is crucial to
critically analyze how the industry specific metric translates to earnings and cash flow.

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Examples:

1. Retail

• EV/EBITDAR – as discussed above.

• EV/m2 – computed as enterprise value per squared meter. This multiple
illuminates the differences in how efficient various retailers are at using their
store space and generating value from it.

2. Technology

• EV/Subscribers – computed as enterprise value divided by the total number

of subscribers.
• EV/Unique Visitors – computed as enterprise value divided by total number
of unique page visitors.
• EV/Page Views – computed as enterprise value divided by total number of
page views.

3. Energy

• EV/EBITDAX – computed as earnings before interest, taxes, depreciation,

amortization and exploration expense. This multiple is often used for mining
companies, since some of these companies capitalize their exploration expenses
while others expense them. By adding back the exploration expense you can
correct for these differences.
• EV/Daily Production – computed as enterprise value divided by the to-
tal daily production output, typically measured in total barrels of oil equiva-
lent per day (BOEPD) when valuing oil producers, or as total mcf equivalent
(MCFE) when valuing dry gas producers. Oil and gas companies typically
report one or the other when communicating their production levels.
• EV/Proven Reserve Quantities – computed as enterprise value divided by
the quantity of proven reserves, typically measured in total number of barrels.

Normalizations of Multiples
To further correct for differences in fundamentals among players in an industry you can
apply various normalizations to multiples. A commonly applied normalization is the PEG
ratio, which normalizes the P/E ratio for differences in growth rates. It is computed by
dividing the P/E ratio by the growth rate of earnings. Another example of a frequently
used normalization is the MTB/ROE ratio, which corrects the M/B ratio for differences
in the return on equity that each company generates. Lastly, you can correct the sales
multiple for differences in profitability using the EV-to-Sales/Operating Margin ratio.

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Conclusion
This document highlights the most prevalent types of multiples in company valuation.
Nonetheless, there several other types available for the assessment of a company’s value.
One important note on multiples is that they are a measure of relative valuation, i.e.
they are meaningless when used in isolation. To make accurate comparisons you must
always understand the components driving the multiple in question and critically analyze
these. For example, a high EV/EBITDA multiple can be an indicator of a relatively high
valuation, but it may also be driven by operating profits of that company being well below
the average. Thus we need to be critical and try to understand where the differences come
from. Multiples can also be influenced by market sentiment, which sometimes leads to
deviations from fundamental value. This is not an issue when the sentiment influences
all players in the market equally, because the multiples are used for relative comparison,
but if market sentiment affects only some firms individually or disproportionately, then
multiples may lead to distorted conclusions on valuation. Make sure to understand the
reasons behind the height of a particular multiple, always critically analyze the relative
comparability, and apply normalizations if deemed appropriate.

Bibliography
Arzac, E. R. (2008). Valuation for Mergers, Buyouts, and Restructuring (2nd Edition
ed.). New Jersey, United States of America: John Wiley & Sons, Inc.
McKinsey & Company; Koller, Tim; Goedhart, Marc; Wessels, David. (2010). Valuation:
Measuring and Managing the Value of Companies (Fifth Edition ed.). New Jersey,
United States of America: John Wiley & Sons, Inc.