It’s not exactly news that multiples are heading south. Data from Preqin and many other sources showed 2007/2008 purchase multiples being north of 8x, often with debt representing 5x. Now however, purchase multiples are more likely to be around 5x, with debt representing about 3x (if you’re lucky). This is a major issue for funds that made purchases at 8x, because they need to use regular value creation tools (heaven forbid), such as sales growth and cost cutting, to keep value from plummeting.

But, that’s another story for another day; I would rather talk about what drives valuation multiples. This can refer to multiples used in fund valuations, deal negotiations, or for whatever purpose. So, the following list describes the individual drivers for proposed purchase multiples of businesses:

• Business size: a larger business has a larger market share (usually), more stability (mostly) and is more attractive to buyers (generally). Therefore, a larger business demands a premium.
• Stability: revenue and earnings stability drives confidence in forecasts and more bankable forecasts demand a premium. Unstable businesses are riskier and require a higher required return, hence a lower multiple.
• Diversification: a business with a diversified product range, customer base and supplier list is less risky. These all affect earnings stability (see above) and hence, influence the multiple.
• Capex: this is often forgotten when just looking at EBITDA, which is why some people use multiples of EBIT (using depreciation as a proxy for capex) or good ol’ FCF (free cash flow, which accounts directly for capex). Capex represents a large portion of costs that don’t hit the P&L (until depreciated), so it’s important to consider capex in your valuation. Reduce EBITDA multiples for high capex businesses.
• Intellectual property: in private equity, we tend not to pay extra for IP because it is often needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP represents greater differentiation, more stability, higher barriers to imitation and less risk.
• Growth: revenue growth is important to private equity because it’s one of the main tools to achieve value creation. So, a business with higher (and realistic) growth forecasts demands a higher multiple. However, it’s important to be pessimistic about management forecasts because 90% of the time they don’t eventuate.
• Synergies: a buyer that has the potential to realise synergistic benefits from an acquisition can generally pay a higher multiple because the acquisition represents a greater value to them. This is one of those drivers that mean the ideal multiple for me can be different to the one for you.
• Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also amplifies returns and reduces the overall cost of capital. The ability to add more debt commands a premium.
• Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is 100% cash up-front, the multiple will be lower than if some of the purchase price is contingent on future earnings. Be very cognisant of the time value of money and that contingent payments have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A much higher multiple can be shown on paper through deal manipulation.
• Comps: although comparable transactions are the most common drivers of multiples, they are often the least appropriate. Even if exactly the same business sold at exactly the same time, synergies and other buyer-related drivers (deal terms, debt capacity, etc.) can affect the real value of the business. But in saying that, you’ll almost never see the same business for sale at the same time, so many other variables are introduced. So, it’s best to be more objective and concentrate on the more fundamental drivers that I’ve listed above.

As always, if you have anything else to add or disagree with my points, please leave a comment.