Capitalisation Multiples
How do you determine the correct capitalisation multiple in valuing a private company using the maintainable earnings approach?
The choice of capitalisation multiple (also described as capitalisation factor) is a key assumption in valuing private companies based on future maintainable earnings.
Typically, the valuer applies the multiple to Earnings after Tax, Depreciation and Amortisation, known as “EBITDA”, and thus the multiple is described as the EBITDA multiple. The multiple is applied to the EBITDA figure to give an Enterprise Value. It is important to understand if the maintainable earnings adopted is EBITDA or whether the valuer is using Profit after Tax, “PAT”. In adopting EBITDA, the earnings do not deduct depreciation and thus are not allowing for replacement of fixed assets. This means the EBITDA multiple is lower than the PAT multiple which includes a deduction for depreciation. The final valuation should be the same whether an EBITDA or PAT multiple is used.
In essence the multiple is a broad approximation to the number of years a buyer is prepared to wait for the return of their investment to materialise. A low multiple indicates a riskier return where the buyer requires a return in a small number of years. A higher multiple indicates a longer-term investment where the buyer is prepared to wait for the return.
Very small family companies or one-man companies will normally be ascribed a low multiple of less than five but every company is different and there is no hard-and-fast formula.
In considering the appropriate multiple the starting point is:
i) The longevity of the company’s trading;
ii) Consistency of underlying operating profits/EBITDA;
iii) The recent growth profile of the company and the stability in the sector and the wider economy;
iv) Any reliance on a major supplier and the concentration of sales to one or a few customers;
v) The sector in which the company operates, general market data and the evidence provided from published databases;
vi) Any previous share transactions in the company.
An approach is to look at the published P/E (price/earnings) ratios of a similar quoted company and then to apply a discount to the quoted multiple. In practice, it is very hard to identify a comparable company. An alternative is to use the industry sector P/E index published by the FT and again to discount it for the size of the company.
Other sources of multiples include the generic private company indexes published by UK200 Group or the BDO PCP index. These are not sector-specific but provide an indication of the multiple applicable to smaller private companies at a particular time.
Finally, there is detailed data published by “BVB” (Business Valuation Benchmarks Limited) which provides the detail of all published transactions on an annual basis. The transactions are split by sectors and thus both individual transactions and sector averages can be extracted.
The expert valuer will consider all the external data available and their own knowledge of the particular company and the wider market to select an appropriate multiple. Business valuation is both an art and a science.
In reviewing a company valuation which is based on maintainable earnings it is helpful to consider the impact of the chosen multiple on the resulting Enterprise Value.
Example
If we assume the valuer of Smaug Limited has assessed the maintainable earnings as £500K. Applying a multiple of say three gives an Enterprise Value of £1.5 million. Another valuer (or potential buyer) might ascribe a multiple of five thus increasing the Enterprise value to £2.5 million. Increasing the multiple from three to five increases the valuation by £1 million, a 67% increase.
Conclusion
The selection of the capitalisation multiple is one of the key judgements in valuing a private company. There is a wealth of market data available but ultimately it is the role of the expert valuer to select a multiple which in their opinion best reflects the attributes of the company being valued whilst considering the wider economic scenario.
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