HARVA RD BusINESsssCHOOL

9-206-095
REV: OCTOBER 31, 2006

ROBIN GREENWOOD

LUCY WHITE

Introduction toValuation Multiples

Amultiple is a market price per unit, which, when multiplied by the number of units, gives the
value of those units. We use multiples regularly in our everyday lives without even realizing it. For
example, to determine the value of a bag of fish, we multiply the price of fish per pound the
multiple) by the weght of fish0n the bag (the number of units). Below are some more examples of
multiples you may have used.
Table 1 Everyday Multiples

Quantity X Multiple Value

Pounds of fish X $ per pound Cost of fish

Bushels of apples X $per bushel Value of apples
Gallons of gasoline X $ per galon Price of tank of gas
Number of square feet X $ per square foot Value of property

In real estate transactions, realtors often make a first estimate of the value of a property based on
the number of square feet times the prevailing price per square foot in the locality. For example, if
the average price per square foot in your neighborhood is $500,you might think you got a good deal
if you acquired a1000-square-foot apartment for less than $500,000. Although multiples present an
eficient way to value an item, they also pose risks. Not all 1000-square-foot apartments in a
particular neighborhood sell for the same price. Other factors, such as supply,condition, and location
of the apartments, may affect the price as well. The risks in applying one multiple ($500/square foot)
to allreal estate in an individual locality are common to all uses of multiples. Thus, it is important to
keep in mind the following basic principles:
1. Multiples are used appropriately when comparing two assets that are similar in nature: One
reason why the price per square foot seems to vary widely across transactions might be that
the apartments are not really comparable; for example, they may vary in quality.
2. Multiples are easy to use when they are stable across similar assets.
3. Multiples may vary over time. The price per square foot is sure to vary as local rents go up
and down, and the price per pound of fish is sure to vary as the seasons change.
The remainder of this note focuses on multiples that are used in financial applications.

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 206-095 Introduction to Valuation Multiples

Valuation Multiples
The most common multiple you willencounter in finance is a valuation multiple. A valuation
multiple is the ratio of firm value (or equity value) to some aspect of the firm's economic activity,
Such as cash flow, sales, or EBITDA. The table below lists the most common multiples used to value
fims, together with the terminology that is used to describe the multiple.
Table 2 Multiples Used in Finance

Quantity X Multiple Terminology Value

Cash Flow X Firm Value/Cash Flow "Cash flow multiple" Value of Firm
EBITDA Firm Value /EBITDA "EBITDA multiple" Value of Firm
Sales X Firm Value / Sales "Sales multiple" Value of Firm
Customers X Firm Value / Customers "Customer multiple" Value of Firm
Eamings X Price per Share / Earnings "Price-eamings ratio" Share Price

The technique for applying a valuation multiple is identical to that of applying a priceper-square
foot multiple to value real estate, or a price per pound to a purchase of fish. If you are studying a
firm with a cash flow of $5 million and you believe it should be valued at a cash flow multiple of 10,
you will determine that the firm is worth $50 million.

Where Do Cash Flow Multiples Come From?

Although it may sometimes seem that multiples fall from the sky, they are related in aprecise way
to the valuation techniques you already know. Recall that the value of the firnm is equal to the
discounted sum of the future (unlevered) cash flows:

PV = CE, CE, -+.. (1)

1+r (1+r)

When the cash flows are growing at a constant rate g, the value of the firm is

PV= CFCEl+g) CE1+g +...

(1+r) (1+r' (1+r)'
CE (2)

Note that in the expression above, the value of the firm is equal to a constant (1 / (r-g) times the
cash flow today. This means that, the value of a firm in which cash flows are appropriately
discounted at a rate r and are growing at a constant rate g can be calculated by using a "cash flow
multiple" of 1/ (r-g). For example, if r=15% and g=5%, the cash flow multiple is given by
1 1
M= =10
0.15-0.,05

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 206-095
Introduction to Valuation Multiples

Why is this cash flow multiple useful? Why not simply calculate the time series of cash flows of
the firn and discount them at the appropriate rate to get firm value?
The answer is that although a shortcut, valuation using multiples has several advantages relative
to standard discounted cash low. First, it requires very few computations. It is much faster to apply a
valuation multiple of 10 to a firm's cash flow of $5 million than to forecast the cash flows ad infinitum
and take a discounted sum. Second, use of the multiple does not necessarily require an estimate of r
Armed
or g. Implicitly, the multiple tells us how the market evaluates r-g for the particular firm.
with this information, we might reasonably apply the same r-g to a competitor firm-that is, value
the competitor using a similar multiple.
While application of a cash flow multiple clearly saves time, is it always correct? Suppose we
observed firm A, in the laundry business, valued at a cash flow multiple of 7. Would we be able to
value firm B, also in the laundry business, using the same multiple? Referring back to equation (2),
we see that the multiple (1 / (r-g) =7) is appropriate only if the cash flows of firm B are expected to
grow at the same rate as those of firnm A. In general, the cash flow multiple approach is valid if (a) the
cash flows grew at a constant rate g, and if (b) the cash flows of the "comparable" firm are
proportional to the cash flows of the firm (or group of firms) whose multiple we are applying to the
firm. These assumptions might hold if the firms are in the same industry and cash flows are growing
at a stable rate, but might fail if the cash flows are unstable or if future competition is expected to
change the growth rates of cash flow over time.

EBITDA and Sales Multiples

As we saw above, the cash flow multiple is primarily useful when the firm is in a
period of stable
growth and margins. But it can be misleading if a firm's free cash flow is temporarily low because of
a large one-time capital expenditure, or because of a large one-time change in working capital.
For this reason, during the 1990s, EBITDA mnultiples became a popular way of valuing firms.
relationship to the NPV
Unlike the cash flow multiple, the EBITDA multiple does not have a direct
formula. Recall

CF = EBITDA(1 -t)+ t- Dep-Capex - ANWC (3)

The intuition behind the EBITDA multiple says that if the right-hand-side terms of equation (3),
then multiplying
t Dep -Capex - ANWC,are small, or if not small then proportional to EBITDA, The benefit of
a constant.
cash flow times a constant is the same thing as multiplying EBITDAtimes
out to be zero,
this is that we can ignore fluctuations in t· Dep-Capex - ANWC (which might turn
estimated value if
strong effects on our
on average, but large in any given year), which would have
we were to apply a cash flow multiple.

A similar logic has been applied to explain the applicability of sales multiples, or customer
stream of sales (or
multiples. If the ultimate cash flows of the business are proportional to the
firm as a constant times this year's sales.
customers) today, then it may be appropriate to value the be treated with caution because the
However, these alternative valuation multiples should always
may or may not hold. Not
assumed relationship between sales (or customers) and cash flows late 1990s as investors
surprisingly, these alternative valuation approaches gained popularity in the
had considerable sales or EBITDA, but negative cash flow.
tried to put a value on firms that alternative multiple approaches to
Following the crash of Internet stocks in early 2000, theseEBITDA were not always indicative of
valuation fell out of favor as investors realized that sales and
Buffet, a long-time critic of
future cash flow. This was perhaps best captured by investor Warren

to Auo 2025
Sharma's Dr R. Satya Krlshna Sharma at Gitam Unlversity from Fab 2025
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 206-095
Introduction to Valuation Multiples

BBITDA multiples, who asked, "Does management think the tooth fairy pays for capital
expenditures?"

Transactions versus Trading Multiples

To apply a multiple in your valuation of a firm or project, you must first figure out what the
multiple is. Typically, you will have to estimate the multiple by looking at
looking at multiples paid for acquisition of similar (public or private) firms. similar companies, or by
Trading multiples The most common way to calculate a valuation multiple is to identify a set
of comparable, publicdy traded firms, and calculate their enterprise value. Next,
enterprise value to cash flow (or EBITDA, sales, etc.), for each of these firms. Thiscalculate
yields
the ratio of
the multiple
for each of the comparable firms. If the multiple varies
worry that you had not chosen comparables well and you significantly over comparables, you might
have settled on a list,you should take the following steps: may choose to review your list. Once you
Table 3 Technique for Calculating a Trading Multiple
1. Identify firms with similar cash flow
prospects.
2. Verify that cash flows or EBITDA are expected to grow
similarly across comparables.
3. Calculate enterprise value for each firm, as the market value of equity
plus the value of debt.
4. Calculate the ratio of enterprise value to the appropriate unit
etc.). (e.g., cash flow, EBITDA, sales,
5. Calculate the multiple as an average (or weighted average) of
firms. the multiples of the comparable

Transaction multiples Another way to value comparable firms to use the value that may
have been paid for comparable firms in a merger or acquisition. The steps involved are
the steps outlined in Table 3, except that the focus is solely identical to
on firms that were acquired. This means
that the enterprise value of the firm is not the traded market value of equity
plus debt, but the amount paid for the equity, plus debt, by the acquirer. (on the stock exchange)
The transaction multiple
frequently exceeds the trading multiple for several reasons. A simple way to understand
higher transaction multiple implies a higher 1/ (r-g) for the firm. Holding the discount ratethis is that a
r constant,
this implies a higher growth rate g. Why might this be true? Often, acquirers will
growth rate of cash flows is higher due to synergies between the acquirer and target. argue that the

Applying Multiples
The valuation you arrive at using a multiple that is based on
the valuation arrived at using the discounted cash flow method, comparable firms should be close to
since these are different methods of
valuing the same object. In practice, however, valuations may not line up. This could
occur for
several reasons. One possibility is that the firms selected as comparable were not chosen well,
perhaps differing in some important way such as growth prospects or riskiness of cash flows.
Another possibility is that the cash flows of the firm, or the firms selected
expected to grow in a stable pattern. This might occur if the firm is expected toas make
comparables, are not
investments in Capital Expenditure, followed by short streams of positive cashoccasional large
flow. A fnal

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 206-095
Introduction to Valuation Multiples

possibility is that the market valuation on which our multiple is based is simply wrong. Put simply,
the market values these firms differently than a fundamental valuation would. In this case we should
our
review our analysis carefully to consider its implication. Does the difference arise from
expectation of synergies or other cost savings that we have built into our discounted cash flow
analysis that other purchasers do not anticipate? Or does the difference arise rom a difference in
-between ourselves and the market? In general it is
beliefsfor example, about growth prospects
good practice to value firms using both the discounted cash flow and the multiples method; whern
these methods give the same answer they increase our confidence in our estimate; and when they
differ we carn ofen learn something from the difference that will help us to refine our analysis.

Sharma's Dr R. Satya Krishna Sharma at Gitam Unlversity from Feb 2025 to Aua 2025.
This document is authorized for use onty In Dr R. Satye Krlshna