The market approach is very popular in valuation. One simply multiples a financial metric, e.g., revenue or EBITDA, by a market multiple. For example, with 5.0x EBITDA multiple, a company with $10 million in EBITDA is worth $50 million. Comparable publicly traded companies or transactions (the “comparables”) provide the multiples.

The simplicity is deceiving. A lot can go wrong in finding the right multiples or in the financial metric to which they are applied.

Issue #1: Calculating the Multiples.

 

The market multiple can produce different levels of value depending on what is in the numerator. Business Enterprise Value is consistent with the market value of total invested capital (Equity + Debt). Many practitioners prefer Enterprise Value, defined as total invested capital less cash (Equity + Debt – Cash). You can use market capitalization to determine the multiple that yields equity value (not ideal).

The same consistency must apply to the Financial Metric. For example, each time period has its own EBITDA and its own EBITDA multiple. In all likelihood, if you did not calculate the multiples yourself, you are applying them incorrectly.

Issue #2A: Selecting the Multiples.

 

A set of comparables (several are commonly needed) will yield a set of multiples for each type of multiple. For example, five comparables will provide 10 multiples when analysis requires two types of multiples.

To select the appropriate multiple, one has to align the subject company’s financial performance with that of the comparables. An analyst may compare growth rates, profitability, or strategic opportunities and risk factors. A revenue multiple for a fast-growing or large, profitable company may overstate value when applied to a less fortunate peer. A smaller company may warrant lower multiples due to its unique risk factors, such as customer or product concentration.

Issue Number 2B: Selecting the Multiples with Regression Analysis.

 

In fact, revenue growth or profitability may not always affect the multiples. It is even harder to quantify the impact. A more nuanced look requires a regression analysis (very simple in Excel).

With enough comparables, one can analyse the correlation between a multiple and a financial metric. A linear regression will reveal which financial metric most strongly influences the multiples. It will also provide a formula to quantify the impact. Although, despite all the math words in this paragraph, the conclusions are never very precise.

Issue Number 3: Using the Correct Financing Metric.

 

The market multiple is a multiplier for the same financial metric used to derive that multiple. Examples of mismatch include:

• Multiples of Revenue are commonly based on public company US GAAP revenues. There is a mismatch when such multiples are applied to annual recurring revenue (“ARR”). Since US GAAP revenues are subject to complex and impactful revenue recognition rules, the error will be substantial.
• Financial Metric timeframe, e.g., last twelve months, trailing twelve months, current fiscal year, or next fiscal year. Each timeframe has its own multiple. Say your revenue grows 10% year, an inconsistent timeframe may lead to a 10% error in valuation.
• EBITDA adjustments are dangerous. Frequently quoted EBITDA Multiples are based on US GAAP EBITDA. Adjusted EBITDAs are not the same. They may exclude stock-based compensation, non-recurring, or non-strategic items. An adjusted EBITDA and a generic EBITDA multiple frequently don’t match.

While much of financial valuations is subjective, these errors must be avoided.

Issue Number 4: Multiples are Date Specific.

 

Multiples change every day, as stock prices do. Once a valuation date is set, multiples can be calculated. Valuation analysis should not rely on anyone’s experience or gut feel.

Calculating date-specific multiples is possible when using publicly traded companies. Market multiples from comparable acquisitions are acquisition date specific. While it is common to use these aged multiples, it rarely makes sense to go beyond a few years. In fact, the gap between the desired valuation date and the transaction closing date can disqualify a multiple entirely.

Conclusion

 

The market approach is a shortcut to a real forecast-based valuation. A market multiple is a black box that condenses all future opportunities and threats into a single number. We can guess what’s inside the box, but we never know how impactful or how risky these factors are in a strict quantitative sense.

The market approach is also hard. It requires a lot of data, careful calculations, and at times statistical analysis. A simplistic back-of-the-envelope calculation often gives only an appearance of an analysis.

Yet, a properly constructed market approach can be very powerful, especially when comparables are good. The multiples are observable, contemporaneous, and consistent across similar companies. They are clear indicators of value and are widely used in pricing acquisitions.