business & goodwill

valuation group pty ltd

what do
valuation
multiples
really
mean?

Elements of a multiplebased valuation

Jack Mordes
Principal
bgv group

Valuation methods
There are many approaches to valuing a business
including:
Capitalisation of earnings or multiplebased valuation;
Discounted cash flow (or DCF) model;
Asset-based approach; or
A rule of thumb valuation such as a per
bed valuation for a hospital.
Although a discounted cash flow (DCF) is considered the most theoretically correct valuation methodology, a multiple-based or capitalisation of earnings valuation is the most commonly used.
This is largely due to its simplicity, particularly
relative to the DCF method.

A multiple-based valuation involves two distinct but

interrelated steps:
First, a valuer must estimate the future
maintainable earnings of a business; and
Second, multiply (sometimes also called
capitalise) those earnings by an
appropriate capitalisation or earnings
multiple.
For example, if a valuer determines a multiple of 4x
to apply to a business with maintainable earnings of
$500,000, the value of that business will be
$2,000,000 (4 x $500,000).

Determining
maintainable earnings
Determining a businesss maintainable earnings is
not as straightforward as looking at the last few
years accounts. Often, adjustments need to be
made for:
owners salary and other discretionary
expenses;
one-off or non-recurring expenses or
earnings;
the impact of business cycles; and
future growth prospects.
However, the subject of determination of maintainable earnings is worthy of a separate article itself and
here we will only focus on the discussion of multiples.

2007 business and goodwill valuation group pty ltd

VALUEATOR
by bgv group

Factors influencing
the choice of a multiple

Multiples:
what do they mean?

Selecting the appropriate multiple with which to value

a business depends on many factors including:

A multiple also tells us about the returns likely to be

generated from the business.

size of the business:

Take the example of ABC, a business that makes

$1,000,000 in earnings before interest and tax (EBIT)
and is being offered for sale for $5,000,000. The
multiple implied by its sale price is 5x (price EBIT or
$5,000,000 $1,000,000 = 5). But what does this
number mean?

the larger the business, the higher the multiple;

growth prospects:

a business with good prospects for future growth will

generally attract a higher valuation multiple than a
more mature business with limited growth potential;

the businesss risks:

for example, key-man risk, industry and competitive

risks or foreign exchange risk;

size of ownership interest:

in general, the valuation of a controlling interest of a

business (i.e.>50%) will attract a higher multiple than
that which applies to the valuation of a noncontrolling stake;

capital intensity:

if a business can grow without the need for more

capital, then it will attract a higher multiple;

which earnings are used:

the selection of multiple will depend on which earnings measure is being used: (i) earnings before interest, depreciation and amortisation (EBITDA), (ii)
earnings before interest and tax (EBIT), (iii) net profit
before tax (NPBT), or (iv) net profit after tax (NPAT).

If we were to buy ABC for $5,000,000, our return on

that investment would be the earnings we could generate from it. On a pre-tax basis, this would be
$1,000,000. So, our return would be earnings
amount invested. In ABCs case this is $1,000,000
$5,000,000 = 20% = 1/5.
Accordingly, the inverse of the valuation multiple tells
us the return on investment (ROI) that the asset is
likely to generate. A business purchased on a 4x
valuation multiple will generate a 25% return on
investment, a business purchased on 5x will generate a 20% return on investment and so on. This is
set out in the table below.
multiple (x)
1
multiple

= ROI

10

50%

25%

17%

13%

10%

The return on investment implied from a given valuation should be compared to the returns available on
other asset classes in order to determine whether the
investment offers just reward for the inherent risks.
For instance, the return on an investment in ABC
should be compared to the returns available from
other asset classes such as the:
Australian share market (last 4 years
return has averaged ~25% and the long
term average is ~12%);
Residential property average returns of
~10-15%;
International shares of ~10%;
Private equity investments of ~15-25%;
Bonds of ~6-7%
It is important to remember that a high valuation
multiple implies a low return on investment.

2007 business and goodwill valuation group pty ltd

VALUEATOR
by bgv group

Multiple ranges
Preparing even a rough guide as to valuation
multiples is fraught with potential pitfalls. However,
as a general guide, we offer the following insights.
Very small businesses are valued at low multiples
(2-3x) reflecting their size, risk and liquidity of ownership interest. Medium sized businesses are valued
at higher multiples of 4-7x depending on their size
and risk profile. Very large businesses are valued at
multiples of >8x and it is not uncommon for transactions among public companies of well above 10x
reflecting synergy potential and low cost of capital.
The table below outlines the general range of
multiples of businesses of varying sizes and characteristics.

multiple range

2-3x

4-5x

6-7x

>8x

implied return

33-50%

20-25%

14-17%

<12.5%

characteristics

-very small business

-medium to small business

-medium to large business

-very large business

-high key-man risk

-moderate key-man risk

-good growth prospects

-established presence

-high competition

-some growth prospects

-cyclical industry

-growth prospects

-mature industry

-established history

-competitive advantage

-high capital intensity

The table above should not be used other than for

mere informational purposes, as it is possible even
for very small businesses to be valued at a high
multiple if for example those businesses have high
strategic value to a particular acquirer or have developed an asset of high potential value that as yet generates a small (or no) income. Expert advice should
be sought.

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2007 business and goodwill valuation group pty ltd

VALUEATOR
by bgv group