There are various multiples that we calculate in trading comps (EV/Sales, EV/EBITDA, EV/EBIT, EV/Operating Cash Flows, PE, PEG, EV/Operating Metrics etc.). The basic objective of calculating these multiples are;
- Valuation comparison of already listed companies,
- Valuing another company using these multiples
Now the question is how to use these multiples to compare valuation or to value a company. Suppose we are valuing a private company using multiples technique then which multiple is more appropriate to value this company; EV/Sales, EV/EBITDA, EV/EBIT, EV/Operating Cash Flows, PE, PEG, EV/Operating Metrics etc. or we use all of them. In second approach, obviously we would have different-different valuation of the same company under different multiple and in that case as a seller you would like to pick the multiple which gives you maximum valuation and as a buyer you would like to pick the multiple which is giving lowest valuation.
Is there not a lot of ambiguity and confusion?
You would have seen that all multiples are not used at a time to value a company. Which multiple is more relevant to value a particular company depends on various factors including industry in which the company is operating, stage of industry, focus of investors/traders etc. Let’s understand this with couple of real examples:
One of the recent and most talked about deal happened in the recent past was Facebook acquired Whatsapp. Everybody was surprised with the $19 billion valuation paid for Whatsapp. What was the basis of that valuation? Revenue, EBIT, EBITDA or Net Income?.
The answer might surprise you. Basically none of them as currently Whatsapp does not have any revenue stream (app is free for subscriber and company is not advertising on its app). So what made Facebook paid $19 billion fortune. Actually Facebook paid $19 billion for 450 million existing user base of Whatsapp. And this is what the key valuation metrics which market and investors are focusing on in social networking companies (Facebook, Twitter, Linkedin etc.).
Based on user number, Facebook paid around $42 per user for Whatsapp compared to $130 per user valuation what Facebook is having. This is how this industry is currently being valued by investors and traders.
So we can say that the most relevant multiple to value a social networking company in current scenario would be EV/User rather than traditional EV/Sales, EV/EBITDA, EV/EBIT multiple because ultimately their future financial performance would be dependent upon their user base. However investors’ or traders’ focus may change from one variable to another over a period of time. So currently it may be user base which is driving value of social networking companies, but later on they may start focusing on Revenue, EBIT, and EBITDA of the companies. This is what happened with dot com companies. Initially the key variable to the valuation of these companies was number of visitors to their sites which later got converted into financial metrics because ultimately investor want to see these operating metrics deriving the financial performance of the company as the basic aim of any investor is to generate return on his investment.
- Let’s take example of another deal where financial variables were the key in deciding the valuation of the company. In Tata-Corus deal (I like talking about that deal because it was the largest Indian takeover of a foreign company). Tata paid $12 billion to acquire Corus. Based on multiples, Tata paid 6.2x of EBITDA of the Corus. Was this deal cheap or expensive at this valuation, that’s altogether different topic. But why EBITDA was the more appropriate multiple in this deal and in the most of the deal where financials are driving the valuation of the company? Let’s discuss this.
One of the key factor that may affects comparability or utility of multiples are accounting policy differences. For example there are two companies which are exactly same in terms of business, size, profitability and efficiency. However both the companies are having substantial differences in their accounting policies. Due to this difference, both of these companies may be reporting different profit numbers in spite of being same in all aspects (i.e. business, size efficiency, profitability and cash flows). Now suppose market is giving exactly same valuations to both the companies as they know that the difference in the profit of both the companies is only because of accounting policies otherwise they are exactly same. Now in that case, would their earning based multiples be comparable? Not 100% as their earning is not comparable.
If you look at the structure of Income statement, you would find that more you are at the top of it, less would be the effect of these accounting differences and more you come downward on the income statement, higher would be the chances of accounting differences distorting their comparability. For example Revenue is at the top of income statement and you will find that there would be least chances of accounting differences which may affect its comparability. You can easily compare revenue of two companies without worrying much about accounting differences. But if you are comparing net income of the companies, there are good chances of these accounting differences affecting the comparability of this number. It means then EV/ Revenue multiple are the best multiple to compare and value companies. Well not exactly. The main drawback of the EV/Revenue multiple is that the revenue is an incomplete measure of performance as it doesn’t tell about the profitability of the company. However there are industries where Revenue multiple is given more weightage than others.
Retail is one the industries where EV/Sales multiple fits best for following reasons:
- Stable and highly competitive industry. Hard to charge margin from customers different from industry. So by looking at sales, we can easily judge the profitability of the company
- Key performance indicator in the retail industry is sales per square feet. Sales is an important variable for the retail industry. Thus EV/Sales gives better picture then any other multiple
Revenue multiple also works well in case of company/industry where profit measures are unavailable or unreliable.
- Now among the profit metrics; EBITDA, EBIT, Net income, we can say that the accounting differences would have the least affect on EBITDA. EBITDA being at the top income statement among all these profit metrics and that is the reason why EV/EBITDA has become the most common measure of valuation that supposedly overcomes the problem of accounting differences.
Conclusion: There cannot be a blanket approach of using these different valuation multiples to value different companies. Each multiple has its own significance depending upon the particular industry or situation. Using multiple technique to value companies or to compare valuation is more of art than science. So one has to be very careful while using this valuation technique as it looks simple but actually it is not.