Usual multiples and the influence of gearing
Multiples are regularly used to check the plausibility of business valuations. In a capital market-oriented environment, multiples are often used as the primary valuation method. The most common multiples are EBITDA(x), EBIT(x) and the Price-Earnings Ratio (P/E ratio). These multiples are popular because they are based on transparent, readily available data and analysts' estimates of the future business development of peer companies at operating profit and earnings level are often of high quality.
However, few users are aware of the extent to which the gearing of the peer companies and the target company can influence the value determined in connection with multiples valuations. In the case of total value multiples, such as EBITDA(x) and EBIT(x), this effect is still limited, although there is also a certain influence via the tax shield. The effect is evident and not negligible with the P/E ratio.
The influence of gearing on the P/E ratio
Leverage acts as a "risk lever". Higher gearing means more financial risk for the owner, which leads to a higher levered beta and thus higher equity costs. At the same time, multiples and the cost of capital have an inverse relationship. In a company with stable growth ("steady state"), multiples can be derived directly from the cost of capital and vice versa.
The "perpetuity" formula can be understood as a rough indication of the nature of the relationship between the cost of capital and multiples. Higher leverage therefore means higher equity costs and thus a lower P/E ratio. This is intuitively understandable: for two companies with the same level of profit but different levels of risk, investors would generally pay less for the riskier company, i.e. a lower multiple of profit.
When can the effect be high? What alternatives does the rater have?
Valuation errors always arise when the average gearing of the peer companies and that of the target company differ greatly. When calculating the cost of equity, this quickly leads to significant differences. All other things being equal, the cost of equity rises from 10% at a gearing of 100% to 15%. In this case, the P/E ratio should fall from 12.5(x) to 7.7(x) with long-term growth of 2%.
Although this effect is serious, empirical multiples are not usually adjusted accordingly. The risk aspect described above is therefore not included in the valuation. In such cases, the valuer should rely more on total value multiples, such as EBITDA(x) or EBIT(x). The error here is significantly lower, as the dependency on leverage is comparatively low.
Wrap it up!
The consideration of gearing is decisive in the multiples valuation. While the influence of total value multiples such as EBITDA(x) and EBIT(x) remains moderate, equity multiples such as the P/E ratio have a significant influence. Valuers should examine these effects carefully and, if necessary, switch to total value multiples in order to minimize valuation errors.
Related articles
- Gearing is one of the key parameters that can influence valuation multiples. For the broader methodological context, see In-Depth Basics of the Multiples Procedure.
- For a detailed discussion of how valuation methodology and parameters should be applied consistently, see Consistent Application of the Multiples Method.
