Enterprise value is often determined using EBITDA or revenue multiples, or the DCF method. Multiples provide a quick indication based on comparable transactions in the market, but they represent a snapshot in time and are less suitable for startups and fast-growing businesses. The DCF method takes a more fundamental look at future cash flows. In practice, multiples are often used as a cross-check alongside a DCF valuation.
Multiples have been increasingly used in recent years for indicative business valuation. The method is quick, simple and quite accurate. But it is a snapshot, which is less suitable for start-ups and high-growth businesses.
There are many methods for valuing a business, and each method has its pros and cons. Following the lead of publicly traded companies—where this method has been used for much longer—valuation based on multiples has gained significant ground in recent years. A multiple is a number that is usually expressed as “factor x gross profit” or “factor x revenue.”
In the SME sector, the multiples method primarily focuses on transaction multiples, which are based on the recent transaction prices of comparable businesses. The main advantage of using multiples is that the method provides a quick and fairly accurate indication of a business’s current value.
Want to value your business? Then check out our valuation tools and get a valuation report!
This gives a picture of what is currently paid for similar businesses in the relevant industry and is a starting point for price negotiations.
What are the pitfalls of valuation based on multiples?
Although a valuation based on multiples quickly provides an indication of a business’s value, there are also a number of pitfalls. Because transaction multiples reflect a business’s current value, they are less suitable for businesses with significant financial fluctuations, such as startups, loss-making businesses, or businesses with a steep growth curve.
For a start-up with a lot of potential or a growth company with solid future projections, a valuation based on current transaction prices would not give a realistic picture because a large part of the value is embedded in the future.
Another problem with valuing based on multiples is finding a good peer group of comparable companies. These are often businesses in the same industry with similar levels of gross profit or EBITDA. But in addition, other factors play a role in the final sales price, making a comparison sometimes difficult. Consider the region where the business is located or any synergy opportunities for the buyer.
In addition, in practice, a number of adjustments are often applied to the derived multiples. The Brookz Takeover Barometer shows that smaller SMEs often have a lower multiple than larger SMEs. This is due to their dependence on management or on a few large customers. Such an adjustment can sometimes amount to as much as twenty percent of the original multiple.
Why combine multiples with the DCF method?
Ultimately, valuation is not an exact science. In practice, it is therefore wise to use multiple methods in conjunction with one another. Multiples provide a quick initial indication and are often used as a cross-check for the more fundamental Discounted Cash Flow (DCF) method, which focuses primarily on future cash flows.
This combination between the wisdom of the market (multiples) and understanding the value of a business (DCF) avoids vulgar horse-trading and at least leads to meaningful discussion about the true value of a business.
Frequently Asked Questions About Multiples and the DCF Method
What is a multiple in business valuation?
A multiple is a number that expresses enterprise value as “factor x gross profit” or “factor x revenue.” In the SME sector, transaction multiples—based on recent transaction prices of comparable businesses—are the primary focus.
What are the pitfalls of valuation based on multiples?
Transaction multiples are a snapshot in time and are therefore less suitable for businesses with significant financial fluctuations—such as startups, loss-making businesses, or businesses with a steep growth curve—because a large portion of their value lies in the future.
What is a peer group when valuing a company using multiples?
A peer group is a group of comparable companies, usually in the same industry with similar gross profit or EBITDA, whose transaction prices are used to determine the multiple. Factors such as region and potential synergies for the buyer can sometimes make it difficult to make a good comparison.
Why do smaller SMEs often have a lower multiple?
Smaller SMEs often have a lower multiple than larger SMEs, mainly due to their greater dependence on management or on a few large customers. Such an adjustment can amount to as much as 20 percent of the original multiple.
Why combine multiples with the DCF method?
Multiples provide a quick initial indication based on the market, while the DCF method takes a more fundamental look at future cash flows. By combining both, you can avoid haggling and engage in a meaningful discussion about a business’s true value.
