What are Multipliers?
Multipliers are financial ratios that are commonly used by professionals in the field of business valuation services to determine a company’s approximate fair market value. They are typically computed by comparing the financial metrics of a company to established industry norms in the form of ratios, ranges, averages, or benchmarks.
Multipliers are applied to different financial variables of the company like revenue, earnings, or cash flow, among others. For instance, the price-to-earnings (P/E) ratio is a common type of multiplier, which is found by dividing a company’s valuation by its earnings.
Why Are Multipliers Significant?
Using multipliers to value a business is significant because it allows potential buyers or investors to determine the company’s economic value. A well-calculated usage of these valuations can save investors from overpaying by being aware of the approximate fair market value.
Several factors can affect the value of a business, such as industry trends, macroeconomic factors, competition, management’s effectiveness, or financial performance. Multipliers offer a more comparative analysis of different companies, where the performance of a particular company’s financial indicators is analyzed in relation to its competitors within its sector, region, or industry.
How are Multipliers Used in a Business Valuation?
A business valuation typically establishes the fair market value of a private company. Fair market value is defined as the price an informed buyer would be willing to pay to acquire the business based on the financial information available at the time of the valuation.
Valuation professionals use multipliers in the discounted cash flow method, which is a widely accepted business valuation approach. This method forecasts the expected cash flow streams of the business in future periods, which are then discounted back to the present value using a chosen discount rate.
To determine the value of the business, the enterprise value (EV) is calculated, which reflects the total value of the business before factoring in cash, investments, and other non-operational items. This figure is then divided by the company’s earnings, cash flow, or revenue, giving us the multiplier ratio that is used to estimate the company’s value.
For example, if a business has an EV of $1 million and earnings of $200,000, the P/E ratio can be calculated as 1 million / 200,000, which equals 5. This implies that a potential buyer might be willing to pay five times the earnings of the company, which would value the business at $1 million.
Conclusion
Multiples are widely used in business valuation services, providing insights on the businesses’ different financial aspects or industry comparisons, among others. They bring useful comparative metrics, which assist everyone, from potential buyers to current investors, in determining a company’s worth, making them an invaluable tool for the valuation of a business. Hence, it’s essential to understand how multipliers work, along with the criteria for selecting them while valuing a business.