Valuation Multiples: Full Tutorial, Example Calculations, and Interpretation

Valuation Multiples Definition: A valuation multiple equals a company’s Equity Value (Market Cap) or Enterprise Value divided by a financial or operational metric, such as Revenue, EBITDA, or Monthly Active Users; valuation multiples tell you how cheap or expensive a company is in relation to similar companies.

The easiest real-life analogy here is to real estate.

Suppose that you’re thinking about buying two homes: One that costs $200K and one that costs $500K.

If both homes are the same size, such as 3,000 square feet, and they’re similar in all other respects, this is easy: The $500K one is more expensive.

On a per-square-foot basis, the $500K house is $167 per square foot, and the $200K house is $67 per square foot.

But now consider what happens if the houses are very different sizes:

The $500K house is still “a higher price,” but it is only $100 per square foot, while the $200K house is $200 per square foot.

So, you get more for your money with the $500K house.

Valuation multiples do the same thing but for companies rather than homes.

For example, if Software-as-a-Service (SaaS) Company A has an Enterprise Value of $800 million (what its core business is worth) and SaaS Company B has an Enterprise Value of $500 million, Company A might seem more expensive.

But now let’s say that Company A has Revenue of $200 million, while Company B has Revenue of $75 million.

Company A’s revenue multiple – a valuation multiple based on Enterprise Value / Revenue – is 4x, while Company B’s is 6.7x.

Therefore, you pay more for each $1.00 of sales if you invest in Company B.

Is this higher multiple justified?

We can’t tell without knowing more about both companies.

People get valuation multiples wrong because they often stop here and say, “Company B is expensive!” or “Company A is cheap!” without understanding why.

We need to look at each company’s growth rate, margin, cash flow, SaaS metrics (ARR, ARPU, Rule of 40), markets, competition, and other qualitative attributes to say anything substantive.

Files & Resources:

• Valuation Multiples – Example Calculations for Target (XL)
• Valuation Multiples – Slides (PDF)
• Target – Highlighted 10-K (PDF)
• Target – Highlighted 10-Q (PDF)

Video Table of Contents:

• 0:00: Introduction
• 0:44: The Short Version
• 4:42: Part 1: Example Valuation Multiples
• 7:20: Part 2: Example Multiple Calculations
• 10:59: Part 3: The Theory Behind Valuation Multiples
• 13:09: Part 4: Why the Theory Often Fails in Real Life
• 14:57: Recap and Summary

Examples of “Generalist” Valuation Multiples

First, there are the “generalist” valuation multiples that you see in nearly all industries:

• Enterprise Value / Revenue: Indicates how valuable a company is in relation to its net sales.
• Enterprise Value / EBITDA: Indicates how valuable a company is in relation to a “rough proxy” for its cash flow from core business operations.
• Equity Value / Net Income (P / E): Tells you how valuable a company is in relation to its after-tax profits, or “how much you’re paying” for each $1.00 in after-tax profits.

There are close variations as well, such as Enterprise Value / EBIT.

EBIT is a company’s Operating Income, sometimes with adjustments, but it does not add back the non-cash Depreciation & Amortization expense.

As a result, it partially factors in the company’s capital costs (spending on factory, equipment, buildings, etc.), so the TEV / EBIT multiple reflects the company’s spending on long-term assets more than TEV / EBITDA.

You can pair a financial or operational metric with Enterprise Value vs. Equity Value based on this simple test:

1. Does the metric deduct the company’s Net Interest Expense? If so, it pairs with Equity Value (e.g., Net Income).
2. OR does the metric represent just the common shareholders? If so, it pairs with Equity Value (e.g., Book Value).

If neither of the above is true, then the metric pairs with Enterprise Value.

For example, EBITDA does not deduct a company’s Net Interest Expense, and it represents all the investors in the company.

Therefore, it always pairs with Enterprise Value.

On the other hand, a metric like Free Cash Flow deducts the company’s Net Interest Expense because it starts with Net Income, so it pairs with Equity Value.

With other variants of Free Cash Flow, such as Levered Free Cash Flow (LFCF) and Unlevered Free Cash Flow (UFCF), you can ask the same question:

• LFCF: Deducts the Net Interest Expense, so it pairs with Equity Value.
• UFCF: Does not deduct the Net Interest Expense and represents all investors, so it pairs with Enterprise Value (TEV / UFCF).

Industry-Specific Valuation Multiples

In addition to these “generalist” valuation multiples, there are also industry-specific versions.

We don’t have the space here to explain these fully, but we will link to some relevant articles below:

• Commercial Banks and Insurance Firms: Common multiples include Price to Book Value (P / BV), based on Equity Value / Book Value, and variants like P / TBV, which uses Tangible Book Value instead. The P / E multiple is also much more important here. (More: The Financial Institutions Group in investment banking).
• Natural Resources: You will see multiples like Enterprise Value / Proved Reserves, Enterprise Value / Daily Production, and Enterprise Value / Mineral-Equivalent Reserves because these operational metrics are all very important for oil, gas, and mining companies (see: oil & gas investment banking and metals & mining investment banking).
• REITs: Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO) are used instead of Net Income; the multiples are Equity Value / FFO and Equity Value / AFFO (see: real estate investment banking).
• Power & Utilities: You’ll see metrics based on key operational metrics, such as the “Rate Base” and the total power production capacity in Gigawatts (GW) or Megawatts (MW). The relevant multiples are TEV / RB and $ per MW or $ per GW for the capacity-based ones (see: power & utilities investment banking).
• Technology / Social Media / SaaS: In these sectors, metrics like the Monthly Active Users, Annual Recurring Revenue (ARR), and Average Revenue per User (ARPU) are very important, so you’ll see multiples such as TEV / MAU and TEV / ARR (see: technology investment banking).

Valuation Multiples: Example Calculations

To illustrate how a simple calculation works, let’s return to the EBITDA tutorial, which was based on companies like Target and Best Buy.

We’ll take Target as an example and calculate its LTM EBITDA multiple in 2 steps:

1. Calculate its EBITDA based on Operating Income + Depreciation & Amortization on the Cash Flow Statement + add-backs for any non-recurring charges.
2. Calculate its Enterprise Value based on its Equity Value – Cash + Debt +/- other items in the Enterprise Value bridge.

Here’s Step 1 for Target, based on its annual and quarterly report:

We’re calculating the Last Twelve Months or LTM figures for the company here to get the most recent data as of the valuation date.

We do this by taking the annual numbers, adding the most recent 6-month period, and subtracting the same 6-month period from the previous year.

Then, in Step 2, we calculate the Enterprise Value by multiplying the company’s diluted share count by its share price as of the valuation date, subtracting Cash, and adding Debt.

These numbers come from public sources like Google Finance and the company’s quarterly filing:

This produces the following valuation multiples for Target:

If we compare Target to other U.S.-based retailers with over $10 billion in revenue, we get the following results for the valuation multiples:

So, is Target expensive or cheap relative to its comparable companies?

Based on this quick screen, we’d say, “Neither – it seems about appropriately priced.”

It has lower revenue growth than the public comps and similar EBITDA margins, which implies that its EBITDA is probably growing more slowly.

But it is also trading at lower EBITDA multiples than the medians of the set, which seems appropriate for its lower growth.

The real answer, though, is that this is not a great set of comparable companies because the 5 companies here are much different sizes – it’s effectively two sets of comps for “bigger retailers” (Costco and Walmart) and “smaller retailers” (Dollar Tree and Dollar General).

The Theory Behind Valuation Multiples

In theory, you can write any valuation multiple formulaically based on the company’s Return on Invested Capital (ROIC) for Enterprise Value-based multiples or Return on Equity (ROE) for Equity Value-based multiples.

For example, you can write the Enterprise Value / EBIT multiple like this:

TEV / EBIT = (ROIC – EBIT Growth Rate) / (ROIC * (WACC – EBIT Growth Rate)) * (1 – Tax Rate)

In other words, if a company’s ROIC is higher, meaning it is more “efficient” at generating profits based on its Invested Capital, its TEV / EBIT multiple should be higher.

If its ROIC is lower, meaning it is less efficient, its TEV / EBIT multiple should be lower.

The same applies to the EBIT Growth Rate: Higher growth means a higher multiple and lower growth means a lower multiple.

If the company’s WACC (a measure of risk and potential returns) is higher, the multiple should be lower to reflect the additional risk.

You can write similar formulas for all the valuation multiples, and on an intuitive level, they are correct.

The problem is that all these formulas assume that the company’s attributes, such as its ROIC, WACC, and Growth Rate, stay constant and that the company has reached a “stabilized” state.

But this is rarely true for companies in real life, which is one reason why these formulas rarely match reality.

Companies grow and change over time, and while they may eventually reach a “stabilized” state, it could take years or decades to get there, depending on the industry.

Theory Meets Reality: Why Valuation Multiples Do Not Always Mean Much in Real Life

Besides the often incorrect “stabilization” assumption, many other issues could distort these numbers.

One common problem is that the set of comparable companies may not be quite so “comparable,” as in the example above:

Dollar General and Dollar Tree are much smaller than Target, but Target is much smaller than Costco and Walmart – and there’s a huge valuation divergence between these groupings.

All this group of comps says is, “Big retailers trade at higher multiples than small retailers,” which is a bit of a silly and anticlimactic conclusion.

Another issue is that valuation multiples mostly reflect a company’s short-term expectations and recent history, so they do not capture the 10 or 20-year outlook.

If a company has a bad quarter, the stock market tends to overreact by punishing its share price, even if the long-term picture remains positive.

Accounting differences can also cause many issues, especially after IFRS 16 went into effect in 2019.

The new lease accounting rules mean that U.S. and non-U.S. companies record leases quite differently on their statements, so metrics like EBITDA and EBIT may not be directly comparable unless you adjust them.

For all these reasons, you should never take a specific set of valuation multiples too seriously.

They mean the most if you compare very similar companies in the same geography with similar revenue, growth rates, and margins.

How to Use Valuation Multiples Successfully

It’s best to think about valuation multiples like blood tests or other health exams when you see the doctor.

If you go in for an annual physical, and your cholesterol or blood pressure is too high, this single test doesn’t necessarily mean you have a problem.

It just means that you may want to dig deeper and see if any other exams or analyses point to potential problems with your health.

Valuation multiples work the same way: They’re indications that a company might be overvalued or undervalued and that you may want to do further research to assess it.

“Further research” means reading about the industry, understanding the company’s role, reviewing its historical reports and presentations, and building your own financial model and valuation.

Valuation multiples are useful supporting tools, but they’re no substitute for a rigorous DCF model built on well-researched long-term assumptions for a company.