What is a valuation multiple and why is it used frequently?
A valuation multiple is a quick way of assessing a company's value, primarily because it's easy to compute.
Fundamentally, a valuation multiple (or simply "multiple") is the value divided by an operating metric of the company.
For example, the relationship of the multiple of revenue (Revenue Multiple) to the value of a business (Business Value) is represented below:
Business Value = (Revenue Multiple) x Revenue
For example, if a company had revenue of $100 in the latest twelve months, and the revenue multiple was estimated to be 1.5x, the Business Value would be estimated as $150. Or, if the Revenue Multiple for that same company was estimated (by a different investor) to be .8x, the Business Value would be $80.
Conceptually, the way to think a Revenue Multiple is: What would a buyer be willing to pay for a dollar of revenue generated by the company. Or, mathematically:
Revenue Multiple = Business Value / Revenue
Is revenue the only metric used? No. The Revenue Multiple is typically the second most used valuation multiple. The most used multiple is the EBITDA Multiple.
Business Value = (EBITDA Multiple) x EBITDA
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. (More here) It is a company performance metric which estimates the cash produced by the company.
EBITDA Multiples are typically higher than Revenue Multiples. If a Revenue Multiple were 1.5x, the EBITDA Multiple might be 8.5x. Why? Because for any given company, the revenue for a given period of time, will always be greater than EBITDA (since EBITDA is net of all expenses). And since the company has only one value (it doesn't have one value based on sales and a second value based on EBITDA) the math follows that the EBITDA Multiple is larger since the company metric is smaller.
Using the earlier example, a company with sales of $100 and a Revenue Multiple of 1.5x has a value of $150. If the EBITDA of the company was $15, then the EBITDA Multiple would be 10x.
If two companies each have EBITDA of $15, would they have the same EBITDA Multiple? No. It would be unusual for the two companies to have the same multiple. Why? Because the industry and future prospects of the two companies may differ widely and those prospects are captured in the value, and valuation multiple, for each company. For example, one company may be in a traditional, low growth industry and the other company may be in technology with many dynamic prospects. While they both have EBITDA = $15, one would expect the multiple for the low growth industry company to be low when compared to the technology company.
Multiples are important for both investors and entrepreneurs when discussing the potential value of any startup business. It's not an exact science. But multiples serve as a common language of value when considering the investment.
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