In-depth basics of the multiples procedure

Basic principle of the multiples method

On the stock market, valuation methods based on multiples have always been among the most frequently used methods in business valuation. Particularly in the English-speaking world, multiple valuations are often considered the primary form of business valuation for IPO sand M&A transactions. Multiples are also regularly used in Germany, but mostly as a plausibility tool behind the primary methods of capital value calculations.

As a relative valuation method, the multiple valuation method is based on a comparative price determination with an extremely simple basic principle consisting of three steps:

1. Search for companies that are comparable to the valuation object.
2. Calculate the quotient of the enterprise value of the peer group companies and a performance-related parameter for these peer group companies.
3. Transfer this ratio to the valuation object.

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The idea behind the multiplier valuation

Capital market theory recognizes the principle of efficient capital markets. Securities that are the same should also have the same price. Otherwise, capital market participants would have favorable opportunities to buy or sell, which would lead to a price alignment. In this context, the same price means, for example, "the same price in relation to net income".

If a comparable company costs 12 times the annual net profit, this ratio should also apply approximately to the valuation object. Manageable deviations are possible, as companies can differ in various respects, but the order of magnitude should generally be correct.

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Systematization of multiples

Multiples can be defined for a large number of basic variables and systematized as follows:

• Entity vs. equity: Equity multiples     relate equity-related variables to market capitalization (e.g. P/E ratio), while entity multiples look at total capital-related variables to     determine enterprise value (e.g. enterprise value/EBITDA).
• Stock size vs. flow size: Stock size multiples refer to a balance sheet figure (e.g. price-to-book ratio), while flow size multiples are aimed at an earnings or cash flow figure     (e.g. enterprise value/EBITDA).
• Trailing vs. forward: Trailing multiples are based on historical reference figures, such as the revenues of the past financial year, while forward multiples are based on forward-looking     figures, such as the expected revenues for the current financial year.
• Trading vs. transaction: Trading multiples are determined on the basis of ongoing share trading by publicly traded companies, while transaction multiples are determined on the basis of IPOs, private M&A transactions or larger capital market transactions.
• Monetary vs. non-monetary: Monetary multiples refer to financial performance measures and dominate valuation practice, but non-monetary multiples are also applicable.

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Selection of the optimal multiples

The practical application of multiplier valuation is determined by various criteria. Here are some examples:

• Data availability: Data used to determine trading multiples is more frequently available than transaction-based data, depending on analyst coverage, the market and life cycle phase of the valuation object and other factors.
• Financial risk: Differences in gearing between the comparable company and the valuation object make an entity valuation preferable.
• Analyst estimates: Analyst estimates are required for forward trading multiples, the standard in multiple valuation. Their quality increases the further up the income statement and the shorter the estimation period.
• Profitability: Companies with loss-making or over-indebted situations cannot be valued on the basis of thePrice-Earnings Ratio or Price-to-Book Ratio.
• Growth prospects: Heterogeneous growth prospects between the peer group and the valuation object require adequate consideration of this value driver, e.g. through the PEG ratio.
• Market standards: Specific multiples have become established in some industries. For example, the price-to-book ratio is often used in the banking sector, while it is less meaningful in sectors with a high proportion of intangible assets.

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Wrapping it up

The multiple valuation method offers a comparative valuation method that is widely used, particularly in IPOs and M&A transactions. The systematic selection and application of appropriate multiples is critical to accurate valuation. SmartZebra's tools and expertisecan help to implement these processes efficiently and correctly.

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