Business Valuation Multiples: Considering Your Client’s Business Interests

In this article, Peter Rahe describes how he presents the subject of market multiples to attorneys. He also raises important questions about business valuation multiples.

Attorneys may be exposed to valuation multiples when gauging the value of their client’s interest in a small- to mid-size company, interpreting an opposing counsel’s proposed settlement agreement, or analyzing the merger or acquisition of a company, so it is important for them to understand the structure of valuation multiples since they are commonly used throughout the course of business. At times, valuation multiples are paramount in negotiations, valuations, and more. Notably, since they tend to have a universal nature, they are easy to understand and maintain a sense of uniformity.

Valuation multiples are market-derived factors used to multiply an economic business benefit to determine value. If a company has annual sales of $1 million and an industry price-to-sales multiple of two, accordingly, $2 million may be the value of the company. There are various valuation multiples to select from and apply when valuing a business. Some of the more familiar valuation multiples may be price-to-earnings, MVIC[1]-to-EBITDA[2], price-to-sales, and price-to-cash flow.

Multiples, being generally easy to understand and apply, may carry a guise of simplicity, and consequently, may elicit the following flawed assumption: If valuation multiples are easy to understand and apply because of their universal nature, then they are inherently simplistic as well, and therefore, a “hard number”—that is, a number lacking subjectivity.

Valuation multiples, however, are far from a “hard number”; rather, they may be easily misconstrued or productively leveraged with the right strategy and information. Therefore, a working knowledge, coupled with awareness of the subjective areas of multiples, can be a powerful tool. Attorneys, by utilizing this information, may be able to create leverage for their client(s).

Multiples—Approaching Value

Three approaches are generally considered when valuing a company: (1) the Income Approach, (2) the Market Approach, and (3) the Asset Approach. Valuation multiples are generally part of the Market Approach and may be applied to a company by using two methodologies: the Merger & Acquisition Method (M&A Method)[3] and the Guideline Public Company Method (GPC Method); collectively, “the “methods”.

The multiples derived from the merger or acquisition of a company (under the M&A Method) can be directly applied to the company being valued (the “subject company”). Suppose a comparable company (similar to the subject company) was acquired in 2012 and the resulting multiple of the transaction was three times the acquired company’s EBITDA; in this case, a multiple of three may be applied to a selected, normalized[4] EBITDA of the subject company to determine value. Similarly, the multiples derived from comparable public companies (under the GPC Method) can be calculated on an ongoing basis, as of a particular date, and applied to the subject company. If, for example, a publicly traded comparable company had a multiple of two times EBITDA as of a particular date, then a multiple of two may be applied to a selected normalized EBITDA of the subject company.

Multiples can also be used as a “sanity check” under the Income Approach to gauge the reasonableness of a business valuation conclusion. The valuation professional will generally determine the subject company’s key multiples resulting from his or her Conclusion of Value. These key multiples can be compared with the multiples found in transactions associated with the M&A Method and with comparable companies classified under the GPC Method, or both.

 Subjectivity

Subjectivity surrounds the usage and interpretation of multiples, regardless of the approach—whether the valuation professional is using multiples as a “sanity check” or directly determining value. Three areas, specifically, may lend to arbitrary interpretations unless supported by relevant factors and data. 

Comparability. The comparability or “likeness” of other companies to the subject company is critical, and very subjective. Therefore, it is important to confirm that multiples derived from the methods are captured from companies that are somewhat similar to the subject company. Focusing on finding a comparable company that is a “perfect match” to the subject company, however, is arguably impossible. Instead, the goal should be to focus on targeting a company with similar characteristics to the subject company, financially and operationally, including relevant qualitative and quantitative factors. “Suitability” may often be an appropriate use of prose when describing the applicability of comparable companies to the subject company; that is, whether the selected comparable company (or companies) is a “reasonably suitable” match to the subject company for purposes of a particular engagement.

Derivation. A multiple is a refinement of a large amount of information pinpointed into a single, seemingly simple number. This number, however, includes growth prospects amongst other factors. A general understanding of how the multiple was derived—because of the variable and extensive amount of information that may be absorbed into a single multiple—is therefore essential. It may be necessary to ask for the underlying assumptions and logic behind why a particular multiple was selected and, when available, review the terms of the transaction of which the selected multiple was based. Unfortunately, for many private companies, the details of the transaction may not be reported (simply because the companies may not be subject to any reporting requirements). Regardless, it may still be important to ask your client, the valuation professional, or opposing counsel (depending on the scope and type of engagement) for the details of any transaction included in a Conclusion of Value.

Context. It is extremely important to be aware of the type of company being valued. While this sounds elementary, having a thorough, logical (and even strategic) knowledge of the subject company will advance the process of selecting a multiple suitable for an engagement. Selecting a price-to-sales multiple for a services company may be a wise choice, as opposed to selecting an EBITDA multiple because of the lower requirement for tangible assets (compared to a manufacturing company that may require a large amount of tangible assets), for instance. This “context” is an important determination, albeit only one of many details to consider.

 Exploring Subjectivity

Knowledge of some of the subjective areas associated with the application and interpretation of multiples is necessary to create leverage for a client; after all, improper interpretation of information may be disastrous to a valuation and may restrict any sought-after leverage. Requesting additional information and asking questions can be helpful. Preliminary questions to ask a client or opposing counsel, such as “Why was a particular multiple selected?” and “What was the source of the multiple?,” may raise some red flags or extract useful information, whereby a valuation professional may be consulted to review all the relevant facts. It is the valuation professional’s responsibility to adequately support his or her valuation. The following are some preliminary questions to consider regarding each of the previously addressed areas:

Comparability

• Are the transactions in a comparable industry relative to the subject company?
• Does the subject company “fit” into any particular industry or industries?
• How does the subject company compare to similar companies within its industry?
• Are there any public companies that would be suitable for a comparison against the subject company?

Derivation

• What were the details of the transaction (e.g., was the acquired [target] company part of a hostile takeover or strategic acquisition)?
• When was the transaction?
• Why was this particular transaction (or why were these transactions) chosen, and why are they relevant?

Context

• What kind of a company is being valued?
• Is the company a service or manufacturing company?
• Does the company clearly fit into a predetermined industry? 

Leverage

 Leverage (different from financial and operating leverage, those foreign financial terms kicked around by valuation professionals) referred to in this article, in its most proverbial sense, will be defined as the “use of existing power, information, and material to obtain a successful result, minimizing overall resource expenditure.”[5] Leverage, regarding multiples, may be applied in two areas by: (1) reviewing the multiples applied to the subject company; and (2) gauging the overall valuation based on the resulting implied multiple of the subject company. Similar principles can be applied to both of the aforementioned areas to create leverage.

Attack the “Gray Areas”

Knowing the subjective areas created when using multiples lends aid in structuring a position. The comparability and derivation of a multiple, as well as the context in which it was used, can create significant leverage. The “context” and “comparability” of multiples, arguably, create an inherent “sliding-scale” (e.g., Exactly how comparable are the guideline companies to the subject company?  Does the subject company really “fit” into the stated industry? Or could it be classified elsewhere?). Therefore, various alternatives may exist, thereby creating an area open for interpretation. Derivation, additionally, lends itself to points of entry for attack; however, it is necessary to dig deeper and exploit the underlying assumptions of a particular derivation. For instance, consider if a particular multiple was derived from the market during a time when acquisitions were “hot” and multiples were inflated. It would be necessary to determine if that type of environment still exists as of the specified valuation date.[6]

Gain Perspective 

Multiples imply value; the higher the multiple, the higher the value of a company, relatively speaking. An overall philosophy and grasp of qualitative and quantitative factors (specific and related to the subject company) can enhance arguments for a client. Therefore, it is important to view “high-level” factors to understand a valuation conclusion and whether or not it “appears” to be reasonable. Some of these factors specific to the subject company include:

• Quality of earnings
• Expected growth rate
• Health of the balance sheet
• Position in the market
• Management of the company
• Acquisition target potential
• Size of the company
• Geographic diversification

Some factors to consider on a global level (not specific to the subject company but nonetheless may affect it) include:

• Current economic conditions
• Anticipated changes in legislation

The preceding factors can strengthen (and conversely weaken) a position. An argument can be made to increase or decrease multiples, and accordingly, adjust the value of the subject company, depending on the interpretation of the relevant factors. A company with a strong quality of earnings and a high expected growth rate coinciding with an economy boasting favorable results of gross domestic product may warrant a higher multiple, for instance; or suppose a company just patented a new product that is expected to have a positive impact on its position in the market, thereby increasing the value of the company, warranting justification for an increased multiple. If even a full valuation of the subject company has not been performed, gaining perspective on a position of value includes consideration of these “high-level” factors.

Benefits

Valuations are subjective and require a significant level of professional judgment—attorneys thereby may capitalize on this piece of information while considering their client’s interest. Valuation multiples, when properly used, are a very powerful valuation tool that helps to aggregate subjective judgments into meaningful benchmarks. Oftentimes under the Income Approach, valuation professionals will calculate the implied multiple of the subject company. The valuation professional calculates the implied multiple after the value of the subject company has already been determined, instead of applying a multiple to a selected financial metric of a company to determine the value. If the subject company’s MVIC is $50 million and the selected EBITDA as of the valuation date is $10 million, then the implied EBITDA multiple would be five, for instance.

Calculating the implied multiple is significant because it creates a relative point of reference for an audience (e.g., judge, opposing counsel, experts, clients, etc.) and can be used to evaluate the overall reasonableness of a valuation professional’s conclusion of value. If, for example, the implied EBITDA multiple is 20, it may be shrewd to consider if the valuation is overly aggressive (or to even consider if there is an error in the valuation), unless the facts and circumstances permit a position to be argued otherwise. Such a position may include espousing to the fact that multiples in the 20s are common in the subject company’s industry. Multiples provide not only a benchmark, but a relevant point of value that can be easily interpreted. It is not as if the multiples have minimal relevance to a company, when the multiples, qualitatively and quantitatively, are the value of a company expressed in a single, consolidated term.

Understanding how the implied multiples were calculated and which financial metrics were used in a valuation is another facet that should be explored; rather than digging directly into the overly technical subject matter, inquiring about the multiples may help to reveal discrepancies (if there were two independent valuations performed) and thus help to determine the overall “big picture” of a valuation. In some cases, the valuation professional may use the subject company’s most recent year’s EBITDA. If the subject company, however, had a lower than normal EBITDA during this year, then the implied EBITDA multiple may seem to overvalue the subject company, when in fact, if the EBITDA was adjusted properly, it may show that the subject company was actually fairly valued. Discussing multiples permits a top-down indication of the value of a company. They are points of reference that can be incorporated into meaningful discussions concerning all involved parties. The simplistic, subjective nature of multiples may lead to areas of opportunity. Essentially, these multiples are aesthetically and intuitively “user-friendly.”

Practicality

In the broadest sense, valuation multiples can be a practical tool used in litigation; from mediation to arbitration or trial, a greater understanding of multiples may be used to protect, leverage, and manage a client’s interest more amicably. Leverage may be created by reviewing the facts of the subject company. Analyzing the subject company in this regard requires not only an understanding of its financial metrics but an understanding of its overall position in the market as well. If a valuation is framed in the right perspective, significant leverage can be created; this perspective, however, may not be apparent unless the company is critically reviewed and analyzed. Revenue Ruling 59–60 states that valuation is not an “exact science”;[7] it is therefore important to consider all the relevant facts and information before simply deciding to take a multiple (or a valuation conclusion, for that matter) at face value, because there may never be one right answer—only alternatives.

NOTES

[1] “MVIC” is an acronym for the “Market Value of Invested Capital,” a business value measure.

[2] “EBITDA” is an acronym for “earnings before interest, taxes, depreciation, and amortization,” a business value measure.

[3] Referred to as the “Guideline Company Transactions Method” as well.

[4] Normalization is the process of adjusting the subject company’s financial statements in order to place these financial statements on an economic basis.

[5] Black’s Law Dictionary.

[6] According to Black’s Law Dictionary, “valuation date” is defined as a “day that an estimator’s value will apply.”

[7] IRS Revenue Ruling 59-60.

Peter F. Rahe, AM, is a senior analyst in the Business Valuation and Litigation Support Group at Meyers, Harrison & Pia, LLC. He has performed valuations of business interests for a variety of purposes, including but not limited to, family law matters, business damages, mergers and acquisitions, and estate and gift tax matters. The subjects of his valuation assignments have included valuations of entire enterprises, partial business interests, public and pre-IPO companies, preferred and debt securities, derivative instruments, and intangible assets. Mr. Rahe can be reached at (203) 466-8363 and by e-mail at prahe@mhpcpa.com.

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