Multiplier assessment – Mystery box with misleading results
“To value is to compare”. Adolf Moxter’s oft quoted aphorism is as true today as it was forty years ago when, as the doyen of business valuation, he prefaced his book titled Grundsätzen ordnungsmäßiger Unternehmensbewertungen [Principles of proper business valuation] with explanations of valuation criteria. In the meanwhile, it has become common knowledge that a value can only exist in relation to something else. The absolute intrinsic value is merely a nullity based on benchmarks that a business itself measures. The multiples-based method is a simple business valuation technique that, despite all its weaknesses, is very popular. Its strengths and weaknesses are presented in the following section.
Perceived strengths of applying this method
The multiples-based method, as a subtype of the market valuation approach, constitutes a valuation technique that seeks to impress with its user-friendliness, simplicity, and speed of implementation. Once the reference value has been retrieved from internal financial data - whether this be EBIT, EBITDA, or sales revenues - and multiplied by the relevant comparative figure, in no time at all you have the sought-after enterprise value. The necessary condition is merely access to industry multiples.
As simple as this method may seem, it is nevertheless misleading. This is due not just to the technique itself, but also the frequently observed way in which it is implemented in practice. This is because the speed of the method is achieved by, among other things, eschewing a robust selection and analysis of the comparable companies.
Issues with the information base among SMEs
First and foremost, the use in the SME environment of industry multiples that have only been scrutinised to a small extent or not at all is open to challenge. The sources available for this purpose are frequently not transparent so that it is not possible to carry out an analysis of the risk structure of the underlying companies. Yet, this is a criterion for comparability, just like profitability, growth and capital structure , that is significantly more important than the similarity of the business model. That is why the grouping in relevant publications of the multiples according to industries can already been questionable. Moreover, the data sources in the SME sector are not always based on market data, but (also) on expert estimates and thus on notional transactions. Experts thus sometimes report, to a database, the assumed multiple for a fictional transaction.
Hidden uncertainties in the estimates and distortions in values
Depending on the circumstances, this will have a greater or lesser impact on the published multiples. This does not necessarily mean that they will be grossly inaccurate, nevertheless, the uncertainties in the estimates will be hidden to the outside with no assessment possible. In the absence of a listing on a stock exchange, transaction multiples are used since trading multiples are not available for SMEs. However, the use of transaction multiples can lead to considerable distortions in values because they reflect the individual synergy expectations of the parties to a transaction. If extreme values (outliers) appear that remain unadjusted and find their way into a published range, then the rash use of the arithmetic mean or the upper or lower values as a limit would be disastrous for an acceptable multiple.
Methodological weaknesses
Whereas the above-mentioned difficulties in dealing with multiples and collecting data about them are justified, the method itself also has a number of weaknesses. Take for example an EBIT multiple valuation; the EBIT that is relevant for the valuation, as an expected value, must in itself already reflect all the future opportunities and risks. It constitutes a sustainable EBIT that will be achieved without delay - therefore in plan year 1. The growth opportunities that should be taken into account are immanent in the multiple. If the expected growth of the subject of the valuation differs significantly from that of the comparable companies used to determine the multiple, then the equivalence required in the valuation method will be disrupted. In a DCF (discounted cash flow) valuation this could be taken into account within the detailed or long-term planning phases. By contrast, the multiples-based method presupposes that the subject of the valuation will immediately transition to a stabilised state. The enterprise value would therefore be 100% generated from the terminal value in relation to around 80% for the DCF method.
Multiples-based method in valuation practice
In professional valuation practice, multiples are rarely used for primary value derivation, at most, they can be useful for plausibility checking purposes. The DCF method is normally given priority. In theory, it is possible to analyse the difference in value between the two methods; however, in the absence of available information this is frequently not further investigated, but instead the relevance of the multiples-based valuation is conclusively rejected. Some multiples are even wholly inappropriate for determining value. Empirical evidence has long shown, for example, that it is not possible to explain a company’s market capitalisation through its sales. If semi-strong market efficiency is accepted as given, then this also negates the usefulness of a sales multiple for valuation purposes.
If, despite all the vagueness, valuation based on the multiples method is not to be abandoned, then the question that arises is: how can its meaningfulness be enhanced? Generally, the main emphasis must be on assessing the quality of the multiples that are used. Their derivation has to be analysed, assessed and, if necessary, adjusted. The same applies to the reference values. The greatest importance should be attached to the analysis of the peer group of companies. There will be cases where this is not possible. In such an event, it would then be better to refrain from applying the method rather than casting a value anchor that is potentially based on a value assessment that is grossly incorrect.
