For the second insight in this valuation series, “Demystifying Valuation Methodologies,” we will discuss commonly used valuation multiples our clients typically employ when attempting to arrive at fair value for their portfolio companies. These multiples include Enterprise Value/Revenue (“EV/Revenue”) and Enterprise Value/Earnings Before Interest, Taxes, Depreciation & Amortization (“EV/EBITDA”) under both Guideline Public Company (Comparable Company) Method in addition to Guideline Transactions (Precedent Transaction) Method.
In the current environment of COVID-19, CFOs are well aware that with the volatility in the public markets, the relative private company valuations using these public company multiples can vary wildly quarter to quarter. Therefore, a discussion of comparable company multiples in some depth is particularly important in order to ensure that the most accurate and relevant data set is selected. While the volatility in public markets cannot be contained, by minimizing the margin for error in selecting the appropriate comparable public companies, the CFO can at least feel more confident in the frameworks developed to estimate fair value.
On their surface, these multiples seem extremely easy to apply. In reality, they are often misapplied and lead to a significant departure from any measure of fair value. Therefore, the valuation of a portfolio company may better present as a reasonable range of value than a point estimate. We will discuss the benefits and pitfalls of the Guideline Public Company and Guideline Transactions approaches, the building blocks (peer group data set) used to derive the multiple, and address each valuation multiple approach with an example.
Although there are many considerations in the multiple selection process, some or all factors may result in a net neutral effect, where the portfolio company has no real significant advantage or disadvantage in the market. The valuator should take into consideration the
following factors before deciding whether an approach using market multiples is appropriate:
Selection of Comparable Company (Peer Group)
We often encounter small start-up companies with exponential growth using the likes of Apple and Microsoft as the foundation of the peer group set used to arrive at fair value. So, are these companies really comparable to the subject portfolio company? Searching for comparable companies in the same industry group is ideal and fits the narrative of peer group analysis. However, the result could be (and often is) meaningless. The reasons are numerous:
When selecting appropriate comparable companies, it may be much more meaningful to find companies that share similar growth and operating metrics, even if not directly in the portfolio company’s comparable set. This might seem counterintuitive to a “comparable” company analysis. However, the public market is more likely to reward a young recent Initial Public Offering (“IPO”) company with a compelling growth story much more than a decades old stalwart with revenues growing at 5% per year and with a 2% dividend yield.
So, it might even make sense to scour the markets for companies with similar characteristics, specifically growth, operating metrics, and capital structure within a broader industry group. Below we illustrate the disparity in fair value that can result from using an inappropriate peer group vs. leveraging a peer group that is truly representative of the portfolio company.
Impact of Peer Groups
Example 1 – Illustrates the impact of utilizing a niche competitor subset versus a broad competitor or industry set. The selection of peer group can have a significant impact on the multiple distribution depending on the observed trading multiples, as well as the forward analyst revenue estimates.
In this example, the portfolio company is a high-growth data analytics software as a service (“SaaS”) technology company, which provides less diversified product offerings than its direct public competitors. In addition, the portfolio company is substantially smaller than its direct competitors but has exhibited significant historical revenue growth over the past three years and has not yet reached profitability as it continues to scale. Given that the portfolio company is not profitable and will not be for the foreseeable future based on its business model, an Enterprise Value/Revenue multiple is the most applicable valuation multiple to yield a company valuation.
As noted earlier, the comparable company sets were divided into two sets in this example: A broad competitor or industry set, versus a niche competitor set consisting of five directly comparable companies, of which a few had just recently gone public within the last few years. The multiple distribution for this data set is much wider, but the portfolio company’s financials more directly compare to the fundamentals exhibited by the comparable companies. The portfolio company is on the high-end of the comparable company distribution in revenue growth and falls within the first quartile of the comparable companies in terms of profitability.
The same is also true for the broader competitor set. However, the portfolio company is significantly smaller than the broader comparable companies selected, and almost all of them are profitable. In both cases,
the rounded first quartile indications were observed to serve as a constant, showcasing that dependency of the distribution based on comparable company selection. If a broad competitor set was utilized, generally a larger discount would apply vis-à-vis a niche competitor set. After analyzing factors such as size, growth, and the breadth of the product or service portfolio, a selected multiple requires a greater degree of judgment on the part of the end user.
Also, we recommend not viewing the comparable company set as a static metric. Comparable companies grow and contract, and the comparable company set should be refreshed at every valuation date to reflect changes. Don’t be afraid to refresh the peer group and document why you may believe an adjustment/replacement might be appropriate if you feel the current comparable company set intuitively no longer makes sense.
Trailing vs. Forward Multiples
Another important consideration in applying a comparable multiple analysis is whether to use a forward multiple or a trailing twelve months (“TTM”) or last twelve months (“LTM”) multiple to the portfolio company. Technically speaking, forward multiples, which are based on projected financial metrics, on their surface appear to be the reasonable fundamental approach as they are used to better incorporate future growth and profitability. However, one of the challenges with this is that company forecasts may not be reliable given the company’s stage of development and operating history. Another challenge is that sometimes, particularly for a thinly-traded company, any depth of analyst forecasts may be completely absent. Therefore, future forecasts may be faulty at best.
While TTM revenue or operating metrics provide some additional certainty and the data for the analysis is readily available, past performance might not be an indicator of future performance. In addition, if a comparable company set and the portfolio company are on a strong growth trajectory, the TTM and LTM multiples may be understated, and therefore they may be considered in combination with forward multiples when estimating portfolio company valuation.
In the current environment of COVID-19, CFOs should be cautious when using forward multiples and perform additional due diligence to ensure both public companies’ and the subject company’s projected financial metrics are current and reasonably adjusted to take into account lower expected performance.
Common Valuation Multiples
Below, we highlight and define common valuation multiples that are most often used by our clients to arrive at fair value for their portfolio companies. We also provide an example for each valuation multiple. We would like to emphasize that valuation is time sensitive, and it needs to be refreshed at least annually to reflect changes in the company’s internal development and external market conditions. In some cases, valuation may need to be refreshed more frequently upon significant value events (for example, new financing).
As a company evolves and matures, both the comparable company multiple method and the precedent transaction method might be applicable during the lifetime of the portfolio company. When switching a valuation approach or valuation multiple, be sure to carefully document why you are transitioning to the new methodology in your valuation policy.
Precedent Transaction
Example 2 – illustrates the considerations taken when analyzing Precedent Transactions within an industry based on a portfolio company with an imminent sale.
Enterprise Value/Revenue
The portfolio company specializes in enterprise communication software. The portfolio company has been experiencing significant historical revenue growth and has been tracking its projections through each projection remeasurement period.
In this example, forward revenue multiples were utilized to determine the value of the portfolio company given that it has continued to track their forecasts and exhibited high growth trajectory. As the portfolio company is substantially smaller, has a less-diverse product offering, and is sacrificing current profitability to scale, its ability to raise future capital is uncertain. Therefore, multiples in line with the low end of the peer group were considered.
Enterprise Value/EBITDA
This portfolio company is an internet software service that specializes in mapping family history and ancestry. The portfolio company has generated significant and consistent EBITDA margins, which are comparable to the upper-quartile of the distributed margins exhibited by the comparable companies.
In selecting the EBITDA multiples for the portfolio company, consideration must be given to the comparability between competitors, as well as the portfolio company’s operating metrics. In this example, given the broad trading multiples data set exhibited by the comparable companies, as well as consideration of the portfolio company’s significant, consistent profitability margins, smaller size, and low-end revenue growth, the median multiples were considered to be reasonable.
In summary, market multiple analysis is a repeatable and transparent market-based valuation approach that can be leveraged across multiple industry verticals. In addition, the comparable company multiples are also flexible in the sense that both comparable company multiple method and the precedent transaction method could potentially be used throughout the life cycle of a portfolio company to arrive at a reasonable range of fair value.
Also keep in mind the portfolio company is still a private company regardless of how far along it is in its growth trajectory. It does not have the ability to raise capital in the public markets and its investors cannot immediately liquidate their shares in a public market. Therefore, the valuation derived from the multiple analysis must be discounted to reflect its status as a private company.
The next part of our series will focus on bringing the portfolio company back to the private realm. Specifically, we’ll explore deriving and applying an appropriate “discount for lack of marketability.”