What it means
The idea is simple: similar businesses should sell for similar prices relative to what they earn. You choose a group of comparable companies, work out the ratio of their value to a measure of performance, and apply the typical ratio to your own company's figure.
The measure might be profit, revenue or cash flow. Common ratios include price to earnings, which compares the share price with profit per share, and enterprise value to EBITDA.
Enterprise value is the total value of the business to all its funders, calculated as equity plus debt less cash, and EBITDA is earnings before interest, tax, depreciation and amortisation. Enterprise-based ratios are popular because they are not distorted by how a company is financed.
The strength of the method is that it is fast, easy to explain and rooted in what buyers are actually paying. Bankers use it in sale processes, investors use it to spot cheap or expensive shares, and founders use it to sense-check a price.
The weakness is that it assumes the comparable companies are truly comparable, which is rarely perfect. Choosing the peer group is the most important judgement.
Companies should be similar in industry, size, growth, profitability and risk, and one-off events should be stripped out of the numbers. A single unusual peer can pull the average up or down, so analysts often use the median, which is the middle value, rather than the average.
A further nuance is that multiples reflect market mood. In an optimistic market, all multiples rise, and a valuation built on them rises too, even though nothing about the business has changed.
Many professionals therefore cross-check a multiples valuation against a discounted cash flow, which values a business from its forecast cash. Adjusting the numbers before applying a multiple is where much of the skill lies.
Analysts remove one-off gains or costs, align accounting policies and consider whether the target is larger or smaller than its peers, since larger firms often command higher multiples. Without these adjustments, the comparison can mislead.
In practice
Real-world examples.
Example
A founder preparing to sell her marketing agency finds that similar agencies sold at about 6 times EBITDA. With EBITDA of $2,000,000 she sets an opening price expectation of $12,000,000 before adjusting for debt and cash. She then asks whether her agency's slower growth deserves a discount to that figure.
Example
An investor screening software companies sees that one trades at 5 times revenue while similar firms trade at 9 times. He investigates whether the lower multiple reflects weaker growth or whether the shares are genuinely cheap. He finds the lower multiple is explained by a recent loss of a major customer.
Example
A bank advising on a merger shows the board a table of peer multiples. The board uses it to judge whether the offered price of $90,000,000 is above or below what comparable deals have fetched. The table also shows the range, so directors can see how far the offer sits from the highest and lowest comparisons.
Formula
Calculation
Enterprise value = Metric x Multiple
Equity value = Enterprise value - Net debt
Suppose five comparable companies trade at a median enterprise value to EBITDA multiple of 8.0. The company being valued has EBITDA of $5,000,000. Enterprise value = 5,000,000 x 8.0 = $40,000,000. The company has debt of $13,000,000 and cash of $3,000,000, so net debt = 13,000,000 - 3,000,000 = $10,000,000. Equity value = 40,000,000 - 10,000,000 = $30,000,000.Case study
Seen in the real world.
Greenfield Bakeries is an illustrative, fictional chain of 40 shops considering a sale. The owner believes the business is worth $25,000,000, based on an offer from a friend.
His adviser gathers four comparable chains valued at 7.0, 7.5, 8.0 and 9.5 times EBITDA, giving a median of 7.75 times. Greenfield's EBITDA is $3,200,000, so the indicated enterprise value is 3,200,000 x 7.75 = $24,800,000.
The adviser then notes that Greenfield has lower growth than the peers, which argues for the lower end of the range, and so recommends discussing a price of about $22,400,000, which is 7.0 times EBITDA. The illustrative lesson is that multiples give a range and a starting point, and the final price depends on judgement about how the company compares.
Watch out
Common mistakes.
- Choosing peers that are not truly comparable and treating the answer as precise.
- Applying an equity multiple such as price to earnings to produce an enterprise value, which mixes up two different measures.
- Forgetting to subtract net debt when moving from enterprise value to equity value.
Questions
People also ask.
Which multiple should I use?
It depends on the industry; profit-based multiples suit mature businesses, while revenue multiples are used for young companies that are not yet profitable. Whichever is chosen, it should be applied consistently to the target and the peers.
Why use the median instead of the average?
The median is less affected by one unusually high or low peer, so it gives a steadier guide. The average can still be shown alongside it to make the spread of results visible.
Is the multiples approach better than a discounted cash flow?
Neither is better in all cases, and professionals often use both to check each other.
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