Multiples, Growth Rates, and Margins

Question that came in the other day

Im confused about how to interpret valuation
multiples. If one companys EV / EBITDA multiple is
higher than anothers, does that mean it is growing
more quickly? Or does that just mean its EBITDA
margins are higher?
In other words, are multiples more strongly correlated
with growth rates or margins?

Multiples, Growth Rates, and Margins

This is a tough question to answer because it depends
on which multiple, which growth rate, and which
margin you are referring to
BUT the short answer is: Valuation multiples are
generally correlated with growth rates because
valuation multiples are shorthand for a full DCF
analysis
Higher FCF Growth Implies a Higher Multiple

Multiples, Growth Rates, and Margins

Point #1: Why Multiples are Shorthand for a Full DCF
Point #2: Does This Really Hold Up in Real Life?
Point #3: Why the Real-Life Correlation is
Sometimes Questionable
Point #4: Recap and Summary

Why Multiples are Shorthand for a DCF

Remember the formula for Terminal Value:
Final Year FCF * (1 + FCF Growth Rate)
(Discount Rate FCF Growth Rate)
Higher Terminal Value: Higher FCF Growth Rate or
Lower Discount Rate
Lower Terminal Value: Lower FCF Growth Rate or
Higher Discount Rate

Why Multiples are Shorthand for a DCF

Multiples: From that Terminal Value you can calculate
the EBITDA Multiple directly correlated
So: Clearly a higher or lower FCF growth rate can
explain a higher or lower EBITDA multiple, but what
about the Discount Rate?
Answer: No, not really! Because typically you assume
the Discount Rate for all companies in a set of public
comps is about the same for that industry/size

Why Multiples are Shorthand for a DCF

Example: Specialty Pharma Companies with Revenue
Between $500 Million and $2 Billion:

These companies should all have similar risk/return

profiles same industry, similar financial criteria
the Discount Rate should be similar as well

Why Multiples are Shorthand for a DCF

So if the Discount Rate is the same or similar for a set
of comparable companies:
Higher Terminal Value and Multiple: Higher FCF
Growth Rate
Lower Terminal Value and Multiple: Lower FCF
Growth Rate
But what determines the FCF Growth Rate?

Why Multiples are Shorthand for a DCF

Components of FCF: Revenue growth, operating
margin, taxes, non-cash charges, Working Capital and
CapEx requirements
Major Drivers: Revenue Growth and Operating
Margin (or EBITDA Margin)
In other words, Operating Income Growth or
EBITDA Growth should be strongly correlated with
FCF Growth, and therefore with the Implied Multiple

Why Multiples are Shorthand for a DCF

OpInc / EBITDA Growth: Margins stay the same
this will move in-line with revenue growth
Margins dont stay the same: All bets are off ex:
increasing margins will drive growth higher
KEY POINT: Its NOT about the margins, its about
how those margins are CHANGING (if they are), and
how those changes impact OpInc / EBITDA Growth

Why Multiples are Shorthand for a DCF

Example: 40% EBITDA margin company and 20%
EBITDA margin company
If theyre both growing EBITDA and FCF at the same
rate, and theyre the same size in the same industry,
the multiples should be very similar
Why? Because the Terminal Value formula doesnt
factor in margins at all! Just the FCF growth rate.

Does This Work in Real Life?

Back to the Pharmaceutical Example:
United: 10% EBITDA Growth, 7x EV / EBITDA
Cubist: 14% EBITDA Growth, 21x EV / EBITDA
Alexion: 22% EBITDA Growth, 23x EV / EBITDA
JAZZ: 36% EBITDA Growth, 11x EV / EBITDA
Salix: 41% EBITDA Growth, 10x EV / EBITDA
MDCO: 137% EBITDA Growth, 9x EV / EBITDA
Not a particularly strong correlation at all why not?

Does This Work in Real Life?

Sometimes yes, sometimes no heres why:
1) Acquisitions! These throw off the growth numbers
2) EBITDA != FCF Theyre often quite far apart, and
other items such as CapEx will impact FCF
3) Valuation Based on Speculation Will the drug
make it through clinical trials?
4) Mispriced Asset Maybe the market got it wrong

Recap and Summary

Valuation Multiples: A multiple like EV / EBITDA
should be correlated with EBITDA growth in the comps
Why: Discount Rate and FCF Growth affect a
companys Terminal Value, and therefore its implied
multiple, but the Discount Rate is similar for most
companies in the set
So: FCF Growth is the key driver, and that should
trend with EBITDA Growth

Recap and Summary

Real Life: This correlation often does not hold up,
especially for speculative industries like
pharma/biotech
Acquisitions and other items that go into FCF could
also distort the numbers
or maybe the company youre analyzing is just
undervalued or overvalued