Although there is ample evidence in the literature that enterprise value has low correlation with earnings or sales, and strong correlation with cashflows, multiples methods are still widely used in the industry. Their main advantage is the “beauty of simplicity”, so that if you are under time pressure or have to generate many valuations in a short time frame, this is the method to choose. Their main inconvenience is that they require substantial experience that only (good) investment bankers or security analysts can have, otherwise they lead to grossly wrong results.
It can be shown that under very special circumstances, multiples-based methods generate the same results as cashflow-based methods. When sales growth is constant and both EBITDA and EBIT margins remain constant in the future – conditions that in practice will never be met – the entity value of a business as calculated by the NPV method can be expressed as follows:
- Entity Value = NOPAT x (1 – g / r) / ( WACC – g )
- NOPAT is the Net Operating Profit minus Adjusted Tax
- g is the growth rate in sales (or cashflow or earnings), assumed constant
- r is the after-tax rate of return on net new investment i.e. new investment after deduction of depreciation in the year
- WACC is the cost of capital.
A prerequisite for the formula to hold true is that the rate of return of future investment r be constant over time. r is calculated as the ratio of the additional after-tax EBIT generated divided by the value of the new investment, so it is the ROIC of future investments. When r is equal to the present rate of return on existing investment, it can be replaced by the current ROIC.
As EBIT and EBITDA margins are constant, NOPAT is simply derived from EBIT:
- NOPAT = EBIT x (1 – tax rate)
The (apparent) advantage of these formulae is that they do not require a detailed forecast of the future of the business: the value of the business today can be derived from its current accounting results, which is a great simplification indeed. The disadvantage of this approach is that it is misleadingly simple and a dangerous short cut: the underlying assumptions are rarely met in practice, in particular the idea that growth is constant into perpetuity. In addition, the Multiples approach does not apply to a new business that has no Sales, or has Sales but negative EBIT or EBITDA. The formulae above also assume that the business remains in operation in perpetuity, which is not the case of projects with limited lifetime.