What is Trading Multiples?
When a company is being valued, sometimes all the values essential for a discounted cash flow valuation will not be available and hence it is imperative for the analyst to take a comparative company, find out the multiple of financial values and use them in our analysis to find the proper metric are called trading multiples.
Let’s say that you’re comparing two companies – Company Y and Company Z. At this moment, as an investor, you only know the share price, the number of shares outstanding for each company, and the market capitalization.
- Comparing the share price of Company Y ($10 per share) and Company Z ($25 per share), you don’t understand anything. How would you tell which company is doing great by just looking at the share price?
That’s why you would look for relative value by using trading multiples.
- First, you saw the earnings per share (EPS) of each company. You found out that the EPS of Company Y is $5 per share and EPS of Company Z is $9 per share. By looking at EPS, you come to the conclusion that Company Z is making more money than Company Y. But that doesn’t mean it has any benefit to you.
- To find out how much you would get out of the company shares if you would buy them in the first place, you need to look at the price-earnings ratio. By looking at the P/E Ratio, you found out that for Company Y, it’s 1.5 and for Company Z, it’s 6.
- Now it becomes clear which company is more profitable for you as an investor. You would get a dollar worth of earnings by paying $1.50 to Company Y; whereas, you would get a dollar worth of earnings by paying $6 to Company Z. That means Company Y is certainly more beneficial for you as an investor.
Also, have a look at this article – comparable company analysis
Trading Multiple Valuation Table – Step by Step
In this section, we will go step by step. We will talk about each step briefly. After going through the whole section, you would get a clear idea of how to use trading multiples for valuing a company.
Let’s get started.
Step#1: Identifying Comparable Companies
Below is the comparable company analysis when I analyzed Box IPO.
The first question the investors ask – how would we identify the comparable companies? The question is obvious. Since there are many companies in the industry, how would one know the right companies?
- First, you need to look for the business mix. Under the business mix, you would see three things – products and services offered by the companies, the geographical location of those companies, and the type of customers they serve.
- Second, you would see the size of the companies. Under the size, you can choose any or all three of the determinants – revenues of these companies, total assets under management, and/or EBITDA margins of these companies.
The idea is to find out the right industry, right services/products, and right trading multiples.
Additionally, as we see above in Box IPO comparable company analysis, we have also included Market capitalization and Enterprise Value. The reason we do that is that we do not want to compare a small-cap company with a large-cap company as their valuation may be different due to different growth paths.
Step#2: Looking at multiples for Valuations
As you already know – there are various multiples we can use for valuing a company. Here, we will talk about the most used and most popular trading multiples.
- EV/EBITDA: This is one of the most common trading multiples. The purpose of using this is EV (Enterprise Value) not only considers the market capitalization, but it also takes the debt into account. Even EBITDA also takes debt into account and not immediate cash items. That’s why EV/EBITDA is a reliable multiple investors/analysts use to value a company. The right range for EV/EBITDA calculation is 6X to 15X in usual scenarios.
- EV/Revenue: This is also another common multiple that is used a lot. This multiple is applicable to those situations where the EBITDA of a company is negative. If EBITDA is negative, EV/EBITDA wouldn’t be useful. And for companies that have just started their journey, a negative EBITDA is way too common. However, EV/Revenue isn’t a great multiple to be used when two companies have similar revenues but can be pretty different in how they operate. When you’re looking for EV/Revenue multiple, 1X to 3X is the right range.
- P/E Ratio: This is another common multiple that investors use to find out about the price they need to pay for earning a dollar. It is almost similar to equity value to net income. The usual range of P/E Ratio is 12X to 30X.
- EV/EBIT: This multiple is specifically useful because EBIT is calculated after adjusting the depreciation and amortization. That means EBIT reflects the wear and tear of the company’s assets and as a result, EBIT shows you the real income. EBIT and EBITDA are close enough, but as EBIT is less than EBITDA, the range of EV/EBIT multiple would be higher, i.e. 10X to 20X.
For the BOX IPO Comparable company analysis, we have included EV. Revenue, EV to EBITDA and Price to cash flow multiples to value the firm. We should ideally show one year of historical multiple and two years of forward multiples (estimated). Choosing an appropriate valuation tool is the key to successfully valuing the company.
Step#3: Comparing the multiples with the comparable companies
This is the last step of the whole process. In this stage, you will look at various multiples of the target company and will compare it with the comparable companies.
As we note from the above table, the general metrics to look at are the simple mean, median, low and high. If a company’s multiple (in this case Box) is above the mean/median, we tend to infer that the company may be overvalued. On the other hand, if the multiple is below the mean/median, we may infer undervalued. High and Low also helps us in understanding the outliers and a case to remove those if they are too far away from the Mean/Median.
We can infer the following from the above table –
- Cloud companies are trading at an average of 9.5x EV/Sales Multiple.
- We note companies like Xero is an outlier that trades at 44x EV/Sales multiple (expected 2014 growth rate of 94%).
- Lowest EV/Sales multiple is 2.0x
- Cloud companies trade at EV/EBITDA multiple of 32x.
Box IPO Valuation using Trading Multiples
- From the financial model of Box, we note that Box is EBITDA Negative so we can’t proceed with EV/EBITDA as a valuation tool. The only multiple that is suitable for valuation is EV/Sales.
- Since the median EV/Sales is around 7.7x and mean is around 9.5x, we may consider making 3 scenarios for valuations.
- Optimistic case of 10.0x EV/Sales, Base Case of 7.1x EV/Sales and Pessimistic Case of 5.0x EV/Sales.
The below table shows the per-share price using the 3 scenarios.
- Box Inc valuation range from $15.65 (pessimistic case) to $29.38 (optimistic case)
- Most expected valuation for Box Inc using Relative Valuation is $21.40 (expected)
Things to Note
- Trading Multiple Valuations is nothing but identifying comparable companies and performing relative valuations like an expert to find the fair value of the firm.
- The trading multiple valuation processes start with identifying the comparable companies, then selecting the right valuation tools and finally preparing a table that can provide easy inferences about the fair valuation of the industry and the company.
- Many trading multiples can mislead you. It’s better if you look for forward-looking trading multiples instead of only looking at the past data.
- EV/EBITDA multiple is one of the best to use if you’re comparing the target company with big companies. For start-ups, one of the best multiples is EV/Revenue.
- P/E Ratio shouldn’t be used at all. There are two reasons behind it. First of all, P/E Ratio is mostly affected by the capital structure. Secondly, the P/E ratio is calculated by taking the overall earnings into account. Overall earnings include many non-operating charges like write-offs, restructuring charges, etc.
Trading Multiples Video
Guide to what is Trading Multiples. Here we discuss how to use trading multiple for valuations along with step by step process to create one for Box IPO. You may also learn more from the following valuation articles –