Consistency of the methodology of the multiples procedure
The multiples valuation - or multiple valuation for short - is a relative form of business valuation. The target company is valued in comparison to similar companies. The basic principle is: companies that are similar in terms of business risk, growth prospects and profitability should also be valued similarly, measured by a multiple of an earnings, balance sheet or cash flow figure.
Consistency of the methodology in the multiples procedure is understood to mean correctly coordinating the essential elements of a multiple valuation. These include:
- Definition of the valuation-relevant reference value for the target company and the comparable companies, e.g. the correct derivation of EBITDA.
- Definition of deductible capital and additions for target companies and comparable companies, e.g. the correct derivation of net debt.
A uniform determination of the valuation-relevant reference value is crucial for a meaningful application of the multiples of the peer companies to the target company. This applies in particular to adjustments of the reference figure for non-sustainable earnings components. These should be consistent in terms of content. In addition, the influence of accounting on the disclosure of the reference figure must be taken into account.
When using total enterprise value multiples, such as Sales, EBITDA and EBIT multiples, the earnings figure is related to the total enterprise value. The deductions and additions must therefore be determined consistently in order to get from the equity value to the total enterprise value for the comparable companies and vice versa for the target company. In addition to financial liabilities and cash and cash equivalents, this applies in particular to pension obligations and financial assets.
Consistency of the parameters of the multiples method
The question of the parameters and their consistency does not initially arise in the context of multiples valuations. However, the valuer should be aware that the value-determining character of the parameters of a DCF valuation - including gearing, the risk-free interest rate and the tax rate - is also retained in a multiple valuation.
While the valuer must explicitly specify these parameters in a DCF valuation, an “absolute” form of valuation, the use of these parameters is implicit in a multiple valuation. This is due to the nature of the multiple valuation as a “relative” form of valuation.
- P/E ratio(x) vs. gearing: The relationship between gearing and the cost of equity is well known. Based on the work of Miller / Modigliani in conjunction with the CAPM, gearing has an effect on the levered beta. It is precisely this relationship that also affects the P/E ratio. The P/E ratio is ultimately the reciprocal of the cost of equity, taking growth into account. A higher gearing increases the cost of equity and lowers the P/E ratio. For the valuation, this means that the gearing of the peer group should be similar to that of the target company.
- EBITDA(x) / EBIT(x) vs. gearing: The aforementioned correlation for EBIT(x) / EBITDA(x) and gearing is less pronounced. Due to the so-called tax shield of debt from the (partial) deductibility of interest from the tax base, taking on additional debt increases the value in a certain area. However, lower costs of capital increase the multiples.
- EBITDA(x) / EBIT(x) vs. tax rate: The relationship between the tax rate and the multiple is clear. A reduction in the tax rate increases the value. As EBITDA and EBIT are tax-independent, this means an increase in the multiple. This is relevant for the user if the peer group companies are based in countries whose tax rates differ from the country of the target company.
What does consistent application mean in practice?
For the multiples method to provide a meaningful indication of value, the target company and the peer group must be analyzed using comparable definitions and assumptions. In particular, the valuer should check:
- whether EBITDA, EBIT, revenue or another reference figure is defined consistently;
- whether non-recurring or non-sustainable items are treated consistently;
- whether enterprise value and equity value are reconciled using the same categories of debt, cash and other adjustments;
- whether capital structures and gearing are sufficiently comparable;
- whether differences in tax rates can affect the selected multiple;
- whether accounting differences between the target company and peer group require adjustments.
This is particularly important when multiples are derived from companies operating in different countries or sectors. A multiple should not be transferred mechanically simply because the underlying companies appear comparable. The economic drivers that determine the multiple must also be sufficiently comparable.
Wrap it up!
In order to achieve meaningful results with the multiples method, it is necessary to apply the methodology consistently throughout. In addition, the valuer should be aware that multiples often have the character of a “reciprocal value” of discount rates. Multiples are therefore subject to the same influencing factors that determine the cost of capital, albeit with the opposite effect.
For further information on the application of the multiples method and other relevant topics in business valuation, please visit our knowledge base or contact us for individual advice.
Related articles
- For a broader introduction to the methodology and application of multiples valuation, see our article on In-Depth Basics of the Multiples Procedure.
- For a closer look at how capital structure affects multiples and valuation results, see Gearing in Multiples Valuation.
