CHAPTER 25

A Brief Discussion of Multiples and Multiple Realities

While Charley was practically shouting at me (mergers and acquisitions, or M&A, is a noisy business, but I suppose that is reflective of the stakes involved), I looked out of the window of the Tyson’s Corner, Virginia high rise his offices were in. I remember from the days I was raising money for a new bank that Tyson’s was something like the eleventh largest city in the United States (and that was in 1984) in terms of office space. Well, I was thinking, that might be great, but so far they had really made a mess out of it, at least in terms of people friendliness. It is basically a high-rise canyon without any charm at all. But it is also a power center for the Northern Virginia Tech corridor. It was the height of the dot.com boom and everybody was feeling fat and happy—invincible, in fact.

Charley, the proprietor of an Internet service provider (ISP), was telling me I was badly mistaken (his words were perhaps a little more colorful than that) with my initial preliminary valuation of his company. He considered himself a competitor of AOL, another Tyson’s area business, but I seriously doubt they had a clue about him. There were dozens of these little ISPs starting up at the time.

The one consolation I got between Charley’s yelling and the ugly and inefficient mess at Tyson’s is that we were high enough that I can look east about 10 miles and see much of the skyline of Washington, DC, my hometown (I have to admit it, even as a native Texan). In my opinion DC is one of the most beautiful cites in the world.

Charley, calmed down a little (I found he did that when you let him vent) and still tried to explain to me that if the value of AOL per Internet subscriber customer was about $1,400, based on AOL’s total market cap, then Charley’s business with 10,000 subscribers logically was worth about $14 million, and I was having a hard time explaining why the mere fact that AOL was a much larger public company with quadzillions of subscribers would make a difference.

Multiples in General

Let’s explore the term multiple a little further in the context of this book, since there are so many widespread misconceptions among lay people about their appropriate use. A multiple is simply a convenient term used in lieu of more formal terms in finance, for more or less the same thing, which are return on investment (ROI ... a form of) or capitalization rate.

To demonstrate as I have previously: If I promise to give you $1 million a year for the rest of your life, and you perceive that you need a 20% ROI, then you will in turn give me (invest with me) $5 million. The multiple of what you get ($1 million) is five times what you will receive. For example, a multiple of four, is equivalent to a 25% ROI, and a multiple of six is equivalent to a 16.7% ROI.

By now, you will have perhaps noticed that by dividing the multiple into 100 you get the ROI or capitalization rate, and conversely by dividing the ROI or capitalization rate into 100 you can derive the multiple. They are simply arithmetic reciprocals of each other or two ways of arithmetically saying the same thing. Pretty simple so far?

Businesses are economic assets. As also discussed previously, economic assets are valued based on the income they will produce to the owner or buyer. By using a multiple of, say, five or six or whatever, or alternatively a cap rate or ROI of 20%, 16.7%, etc., I can determine the value of the underlying asset (more specially the value of its earnings) at that given rate of return. For example, the following illustrates the value of an income stream (think a business) at different multiples, assuming the income continues in perpetuity:

Risk and Multiples

These rates or multiples are directly correlated to the degree of risk perceived by the investor. An investor, according to the theory of substitution, could choose to buy a Middle Market business or invest in a ten-year treasury note. As a ten-year treasury note is about as safe as you can get, you would usually expect to get an ROI of around 4% to 5%. There is a ladder of choices and risks, ranging from the notes at 5%, to large public stocks at, say, 12%, to less-than-investment-grade bonds at, say, 16%, to Middle Market businesses at 20%. For example, (keeping in mind again that all of these rates of return are before the investor’s taxes, although the cash or the equivalent (capital appreciation) returns themselves are after the payers’ taxes, if any):

Note: Another interesting way to look at the multiple is to consider how many years one would be willing to wait to get the original investment back. Note that the riskier the investment, the less one is willing to wait (and the higher the required return).

The Rule of Five (see Chapter 23) suggests that a Middle Market business (not an entity that owns one) will be valued at a five-multiple of its before investors tax cash flow earning stream until there is reason to do otherwise. This is a very useful starting point, as I pointed out in that chapter, and, as I also point out, many Middle Market business sell for and are valued at substantially more or less than multiples of five (or 20% ROIs). It also assumes a going concern, in the sense that the earnings will be received in perpetuity (at least in theory).

Derivative Multiples versus Actual Deal-Driving Multiples

It is not uncommon to pick up the financial press or an M&A reporting service and have a Middle Market deal reported as having been for a multiple of almost anything that the reporter chooses to state it as. For example, in the late 1990s it was not uncommon to have the purchase price of a business expressed as a multiple of some pretty strange and exotic things, like discrete Web site visits, or the number of network engineers employed. Well, folks, these are not what deals are actually (or should be anyway) based on. What they are based on are multiples of cash flow earnings (EBITDA, etc.). Any other multiple is a multiple derived after the transaction was done. And while it was being done, you can be assured that the parties, especially the buyer, were thinking in terms of earnings multiples. If there were not any current earnings, you can bet earnings were at least being projected. (See the DFE methodology in Chapter 24). Furthermore, important aspects of the deal like normalized EBTDA and precise deal terms are usually not known by the reporting service.

While not quite as far-fetched as some of the multiples used in the late 1990s, revenue multiples frequently cited are also ... derivative multiples. They are calculated after the deal is done, but do not drive the deal.¹ Once the purchase price is determined as, say, $10 million, it is easy enough to divide that number by the revenue of $8 million and report that the deal was for a multiple of the sellers revenues of 1.25 to 1.

Well yes, it is a true statement, but it is just arithmetic, not deal making. My advice in general is get your mind off of revenue multiples. They are misleading, except for limited purposes, and then only in the hands of experts and negotiators, and are otherwise pretty useless.²

Public Market versus Private Market Multiples

Another aspect of multiples that needs attention is the difference between public company valuation multiples and private Middle Market company valuation multiples. I have heard some very sophisticated people discourse on the valuation of their private Middle Market companies, while totally misapplying public company multiples to them and, as a result, drawing some very wrong conclusions about their company’s value. I have mentioned elsewhere the phenomena of the roll-up industry, which resurrects its ugly/pretty head periodically. In that phenomenon, which is based really on financial engineering and arbitrage (a price difference for an identical asset in different markets), sponsors go about buying privately held Middle Market businesses, repackaging them, and then reselling them as public companies in the form of IPOs (initial public offerings). Understanding this is a big step to realizing why public multiplies really cannot be used to determine the value of a Middle Market company for transaction purposes.

I do not deny that I and other experts use the guideline public company method (essentially using public company multiples) for formal valuation purposes in courtrooms and so forth to value private companies, but even there it is used with great care, with a number of necessary transformation equations applied (one example is a discount to account for the difference in liquidity between a public and private company), and as only one of several methods. Furthermore the guideline public company method is one that is, in fact, frequently discarded after all the work is done as being not particularly useful, even by formal valuators.

Private Middle Market companies are valued on their earnings, generally modified to a proxy for their cash flows, but which is nevertheless close, as a rule, to the before tax, before interest net income (EBIT) that an accountant comes up with when he does the audit or the company’s tax return. As discussed elsewhere in this book, these earnings are usually multiplied by somewhere between 4.5 and 5.5 (although the multiple can be quite different). And that is how private Middle Market companies are valued (at least on the sales side), but it is not the way public companies are valued.

Public companies are most commonly valued on the basis of after tax earnings, and the multiple that is known most commonly in this market is the price-to-earnings ratio (P/E ratio). This is essentially a derivative multiple that results from the collective votes cast every minute by the shareholders buying and selling stock in a public company, and it reflects the value of the equity alone (market capitalization) rather than the entire enterprise.

Arbitrage and Roll-Ups: A Practical Example of Public versus Private Company Valuation and Multiples

Let’s take a quick look at Company A (see Exhibit 25.1), which is valued as if it is a privately owned Middle Market company on the one hand, and as if it is a publicly owned company on the other. This is particularly revealing regarding the possible arbitrage between buying this company from its private owners, repackaging it with a number of similar companies, and then selling the package to the public market as an IPO. It points out nicely the benefits of price arbitrage, but my main reason for including it is to illustrate the important distinction between valuing a company using private market multiples and public market multiples.

You simply cannot take public multiples as indicative of what a private business is worth for many reasons, including size, similarity (degree or lack of) of the businesses, etc., but a fundamental reason is that the multiples are extremely different in their application, one (private businesses) being a before-entity tax cash flow multiple and the other (public entities (P/E ratio)) being after entity taxes.³ They are usually also very different in magnitude. The private multiples are usually in the five or six range. The public multiples, in the 15 to 25 range, reflect the value of the equity alone (market capitalization) rather than the entire enterprise.

EXHIBIT 25.1 Example of Private to Public Pricing Multiple Arbitrage

It takes just a telephone call (or a keystroke on your computer if you trade online) to sell your pubic company shares, and three days until you are paid. In a Middle Market company, it can take seven to twelve months and longer to liquidate your investment. The difference attributable to this illiquidity advantage is typically around 30% to 40% of the value of the equivalent public shares.

I have seen the misapplication of (or at least confusion in applying) public P/E multiples to private company EBITDA from time to time by laypersons. I also not infrequently see it in studies purporting to reflect M&A multiples based on EBITDA, when actually what is being reflected are public stock prices as a multiple of EBITDA.

Chapter Highlights

• Multiples in Middle Market M&A transactions for private companies are described in the press and reporting services based on very limited information (e.g., normalized EBITDA and precise deal terms are usually not known) and, which affects and limits their usefulness significantly.

• Revenue and second-order or derivative multiples should not be considered very seriously.

• Cash flow (EBITDA, etc.) multiples are first-order (deal-driving) multiples.

• But these are only a referential starting point in M&A deals that are good for:

• Preliminary value in the market place estimates

• Negotiating, in some cases

• And these are the equivalent, mathematically and reciprocally, of a capitalization rate or ROI

• Multiples for private businesses are not comparable to multiples in public companies, because:

• Public company multiples are generally applied to the after tax income of the entity owning the business, and private business multiples are generally before the income taxes of the entity owning the business

• Public company ownership interests are extremely liquid

Notes

1 There are a very few exceptions, particularly in certain few pure professional service business like accounting practices and some consulting firms (but not many others), in which Mom-and-Pop rules of thumb, like revenue multiples, are used or at least referenced. However, in these cases the view is that it is clients being bought, not going businesses, even though some of the staff may transfer and you can be sure the multiples are adjusted for profitability. These exceptions are used only when profitability in that service practice is at fairly standard margin for that industry.

2 It is interesting, at least, to conjecture as to what extent M&A multiples become self-fulfilling prophesies, in the sense that they are derivative multiples at first, but then buyers and sellers come to expect them and thus they start driving deals as opposed to being derived from them. What in large part belies this premise, though, is that if the growth rates that drive rapid growth in an industry disappear, so will the higher multiples. But to some degree there certainly is a momentary sort of follow-the-leader phenomenon.

3 Public P/E multiples may be shown both ways (based on cash flows similar to EBITDA or based on net income) but in each case they are usually shown after entity income taxes.