What are Trading Multiples?

Example

You’re comparing two companies – Company Y and Company Z. 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 looking at the share price?

That’s why you would look for relative value by using trading multiples.

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Also, have a look at this article – fair valueFair ValueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more. The comparable comp process starts 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.” url=”https://www.wallstreetmojo.com/comparable-company-analysis-comps/”]comparable company analysis[/wsm-tooltip].

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 using 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 IPOBox IPOThe analysis of the Box IPO valuation can be done using various methodologies which are Relative Valuation – SaaS Comparable Comps, Comparable Acquisition Analysis, Using Stock-Based Rewards, Valuation cues from Private Equity Funding, Valuation cues from Dropbox Private Equity Funding, and Discounted Cash Flow Approach for Box IPO Valuation.read more.

The first question the investors ask – is 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 EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more margins of these companies.

The idea is to find out the right industry, services/products, and trading multiples.

Additionally, as we see above in Box IPO comparable company analysis, we have also included Market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more and Enterprise ValueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more. We do that because we do not want to compare a small-cap company with a large-cap company, as their valuation may differ due to different growth paths.

Step#2: Looking at Multiples for Valuations

As you already know, we can use various multiples for valuing a company. Here, we will talk about the most used and popular trading multiples.

  • EV/EBITDA: This is one of the most common trading multiples. EV/EBITDA is a reliable multiple investors/analysts use to value a company. The purpose of using this is EV (Enterprise Value) considers the market capitalization and takes the debt into account. Even EBITDA also takes debt into account and not direct cash items. In usual scenarios, the right range for EV/EBITDA calculationEV/EBITDA CalculationEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more is 6X to 15X.EV/Revenue: This is also another common multiple used a lot. This multiple applies 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/RevenueEV/RevenueEV to Sales Ratio is the valuation metric which is used to understand company’s total valuation compared to its sales. It is calculated by dividing enterprise value by annual sales of the company i.e. (Current Market Cap + Debt + Minority Interest + preferred shares – cash)/Revenueread more isn’t a great multiple when two companies have similar revenues but can be pretty different in how they operate. When looking for EV/Revenue multiple, 1X to 3X is the right range.P/E Ratio: This is another common multiple that investors use to determine the price they need to pay for earning a dollar. It is almost similar to equity valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more to net income. The usual range of the P/E Ratio is 12X to 30X.EV/EBIT: This multiple is useful because EBIT is calculated after adjusting the depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
  • read more 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 EV/EBIT multipleEV/EBIT MultipleThe EV to EBIT ratio is an important valuation metric that determines whether a company’s stock is expensive or cheap in comparison to the broader market or a competitor.read more ranges would be higher, i.e., 10X to 20X.

Choosing an appropriate valuation tool is the key to successfully valuing the company. For the BOX IPO Comparable company analysis, we have included EV. Revenue, EV to EBITDA, and Price to cash flowPrice To Cash FlowPrice to Cash Flow Ratio is a value indicator that measures a company’s stock price in relation to the cash flow amount it generates. This is determined as the ratio of Price Per Share to Operating Cash Flow Per Share. read more multiple to value the firm. Ideally, we should show one year of historical multiple and two years of forwarding multiples (estimated).

Step#3: Comparing the Multiples with the Comparable Companies

It is the last step of the whole process. In this stage, you will look at various multiples of the target company and compare it with the comparable companies.

As we note from the above table, the general metrics are the simple mean, median, low, and high. If a company’s multiple (in this case, Box) is above the mean/median, we infer that the company may be overvalued. On the other hand, if the multiple is below the mean/median, we may infer that it is undervalued. High and Low also help us understand 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 are an outlier that trades at 44x EV/Sales multiple (expected 2014 growth rate of 94%).The lowest EV/Sales multiple is 2.0xCloud companies trade at an 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 the mean is around 9.5x, we may consider making three 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 three scenarios.

  • Box Inc valuation range from $15.65 (pessimistic case) to $29.38 (optimistic case)The 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 firm’s fair value.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 to look for forward-looking trading multiples instead of only looking at the past data.EV/EBITDA multiple is one of the best to use when 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, the P/E Ratio is mostly affected by the capital structure. Secondly, the P/E ratio is calculated by taking the overall earnings. Overall earnings include many non-operating charges like write-offsWrite-offsWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more, restructuring charges, etc.

Trading Multiples Video

The article is a Guide to what is Trading Multiples. Here we discuss how to use trading multiple for valuations and a step-by-step process to create one for Box IPO. You may also learn more from the following valuation articles –

  • Wash Trading DefinitionFormula for Equity MultipleOutlier FormulaValuation Analyst Career Path