It’s not uncommon for us to hear about company multiples whenever we flip through finance channels or scroll through the market section in our daily newspaper. Company multiples are an expression of the price of the company based on operating results. Common operating results used include revenues and EBITDA and can either be historical or forward looking. Although there are many factors at play and companies in the public markets involve a great level of complexity, a common factor amongst all companies is expressing what a company is priced in terms of their multiples, be it revenue multiples, earnings multiples or another metric signifying how well (or how poorly) that company is performing.
Although they are not the be-all and end-all metric for a company, valuation multiples are frequently used simply because they are easy to understand and provide a standard measurement for a company when being compared to other companies that may or may not be in the same industry. However, as helpful as they are, these multiples can sometimes be deceiving if it is not understood correctly.
For example, let’s compare two companies that generate the same level of revenues each year. Company A, in this example, has a revenue multiple of 8.0x (i.e., Company A’s business is valued at 8x its annual revenues) whereas Company B has a revenue multiple of 6.0x. Most users would assume Company A is outperforming Company B. Unfortunately, life is never that simple and there are always other factors to take into consideration. What if we said Company A had been losing money over the past few years and has yet to generate any profits, while Company B has stabilized and provided substantial dividends back to its shareholders?
Although valuation theory dictates that the intrinsic value of a company is driven by its present value of the future cash flow the company can generate, multiples in the marketplace are often driven by optimism.
Getting back to our example above, if we add that Company A, even though it is currently losing money, manufactures a product that has the potential to be highly sought after by global businesses in the future (whereas Company B has already matured in its business and expects to only generate the same level of profits each year), then the perspective landscape of these companies changes drastically. Now, Company A might transform itself from a cash loser to a cash machine! As such, optimism may fuel expectations that future cash flow in Company A will exceed those of Company B, leading to the observed higher multiple for Company A.
Markets are, of course, far more complex than the example above and there are many drivers and factors involved in generating a company’s multiples. Nonetheless, we hope this week’s blog provides some insight to what multiples mean.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
CPA, CA, CBV
William Tam is a senior manager at Smythe Advisory, and is focused on providing valuation and financial advisory services to his clients.
Gagandeep specializes in M&A advisory engagements, as well as business valuations in the contexts of management buyouts and succession planning.
Arthur’s mandate is to assist Smythe clients in Western Canada in preparing for and executing business divestitures or acquisitions.