The evaluation of freelance practices, such as medical practices, architecture firms or law firms, remains insufficiently defined in current standards such as IDW S1 or IFRS. However, the Federal Court of Justice has developed clear guidelines for evaluating goodwill in such freelance practices.
What is the basic principle of the multiplier process?
Valuation methods based on multipliers have always been among the most frequently used methods in company valuation on the stock market. Depending on the sector and competitive structure of the valuation object in question, multiple valuations are sometimes even considered the primary form of company valuation in IPOs and M&A transactions, especially in the Anglo-Saxon region. In Germany, too, multipliers are regularly used in company valuation, even though in valuation practice they are mainly used as a simplified form of pricing behind the primary methods of net present value calculations and therefore serve more as a plausibility tool.
The multiplier process as a relative valuation method is based on comparative pricing with an extremely simple basic principle that consists of three steps.
Step 1: Search for companies that are comparable with the valuation object
Step 2: Calculate the quotient of the enterprise value of the comparable companies and a performance-related figure for these comparable companies
Step 3: Transfer this relationship to the valuation object
What is the idea behind multiplier evaluation?
Capital market theory is familiar with the principle of efficient capital markets. Securities that are the same should also have the same price. Otherwise, capital market participants would have favourable buying or selling opportunities that would lead to a price adjustment. In this context, equal price means, for example, “equal price in relation to net income for the year.”
If a company comparable to the valuation object costs 12.0x times the net profit for the year, then this ratio should also apply approximately to the valuation object. Manageable deviations are, of course, possible, but companies ultimately differ in various ways, but the scale should be right in principle.
How can multipliers be systematized?
Multipliers can basically be defined for a variety of basic quantities and can be systematized as follows:
- Entity vs. Equity
- Inventory size vs. stream size
- Trailing vs. Forward
- Trading vs. Transaction
- Monetary vs. non-monetary
Equity multipliers set equity-related figures in relation to market capitalization (example: P/E ratio). Entity multipliers, on the other hand, look at total capital-related figures, i.e. in addition to the market value of equity, borrowed capital is also taken into account in order to arrive at the so-called enterprise value (example: Enterprise Value/EBITDA).
Inventory size multipliers reference a balance sheet size (example: price/book value ratio), whereas electricity quantity multipliers are based on an income or cash flow variable (example: Enterprise Value/EBITDA).
Trailing multipliers reference a historical reference figure, e.g. sales for the past fiscal year, while forward multipliers aim at a future-oriented figure, e.g. the expected turnover for the current financial year.
Trading multipliers are determined on the basis of current share trading of listed companies, and transaction multipliers are determined on the basis of IPOs, private M&A transactions or larger capital market transactions.
Monetary multipliers relate to financial performance indicators; they dominate valuation practice. In principle, however, non-monetary multipliers can also be used.
When to use which multiplier?
The practical application of multiplier evaluation is determined by a variety of criteria. Here are a few examples of which criteria can be relevant when choosing the multipliers used correctly.
Data availability: Data for determining trading multiples is more available than transaction-based data, although in individual cases this may depend on so-called coverage by analysts, the market and life cycle phase of the valuation object, and other factors.
Financial risk: The more the indebtedness ratio of the comparable companies and the valuation object differs, the sooner an entity valuation should be preferred.
Analysts' estimates: For forward trading multiple, the standard in multiple valuation, analyst estimates are usually included in the calculation of the multiplier. Their quality is all the higher the higher in the profit and loss statement and the shorter the estimate period. A 1-year sales multiple is significantly higher in quality than a 3-year profit multiple.
Profitability: The use of multipliers requires a meaningful evaluation context. Companies with a loss or even over-indebtedness situation cannot be rated on the basis of the price/profit or price-book ratio.
Growth prospects: The more heterogeneous the growth prospects of the peer group and the valuation object are, the more important it is to adequately take this value driver into account. Here, for example, the PEG ratio offers an alternative to conventional multipliers.
Market standards: Market standards have been established for some industries. In the banking sector, the price/book ratio is considered a frequently used multiplier, in particular because many banks account very close to the market due to the use of IFRS/US GAAP. In industries with a high proportion of intangible unaccounted assets in the value chain, on the other hand, the price/book ratio is almost inconclusive.