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Simplifying Valuation Multiples – A Primer for Private Business Owners

Simplifying Valuation Multiples – A Primer for Private Business Owners

Valuation multiples are commonly quoted in the media in connection with public equity prices as well as merger and acquisition activity. These valuation metrics appeal to private business owners as they are readily understood and can easily be applied to derive an estimate of value for their own businesses. However, when making these comparisons, it is important to appreciate the theory behind the use of valuation multiples, the assumptions underlying the different types, and their relevance to the particular situation. Business owners should also be aware of certain limitations when applying the multiples of publicly-traded companies to value smaller privately-held businesses.

The Theory Behind Valuation Multiples

The application of valuation multiples across like businesses (commonly referred to as guideline public companies or market comps) is based on the premise that those businesses have similar underlying economics, which are apparent in their financial or operating metrics.

In reality, there is never a perfectly comparable company; some differences are always prevalent including size, product and service offering, geographical outreach, cost structure, quality of management, amongst others.
Accordingly, considerable caution needs to be exercised, and robust analysis undertaken when adopting the multiple of another company that may seem somewhat similar.

Valuation multiples are in effect a simplified form of the discounted cash flow. Mathematically, the multiple is the reciprocal of the capitalization (or “cap”) rate, defined as (r – g) - where “r” represents the required rate of return and “g” represents the long-term growth rate. Hence, a valuation multiple is essentially a derivation of the perpetuity equation, assuming a long-life, going concern with a constant growth rate. Consequently, multiples may be of limited use in instances where the business opportunity has a short life, or where significant growth (or contraction) of a business is expected over the next number of years.

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Contributed by Farhan Fazli, Segal GCSE LLP, Effective July 1. This document was written for our quarterly bulletin, Canadian Overview, published by Canadian member-firms of Moore North America.