The World of Multiples

Business transactions occur in the world of multiples. Say there is a company selling ballpoint pens, making an operating income of $1 million a year. This company has been fairly stable throughout recent years and is expected to maintain at least the current earnings for the next three years. Now, assume there is a private equity (PE) firm that wants to buy this ballpoint pen company. What is a simple but fair purchase price? It would be a fair trade if this PE firm pays a multiple of 3 times the operating income (EBIT). In other words, 3X EBIT.

Then, after the purchase, this PE firm implements some new infrastructure for efficient operations, replaces management with a more competent team, and accelerates the company’s growth. After five years, the PE firm wants to sell this company. But at what price? Now, it’s a different story. This ordinary ballpoint pen company no longer ordinary. It now has incredibly structured logistics operation, reduced overhead expenses, and achieved higher operating leverage on its fixed assets. It is now safe to assume that this company will maintain its current earnings for at least seven more years. What is a fair multiple of this company now? Assume 7X EBIT. If the PE firm sells the company at 7X EBIT, it has made itself a lot of money.

Let’s put some context into this example.

1. Company A sells ballpoint pens and has annual EBIT of $1mn.
2. It is sold to a PE firm, B, at 3X EBIT, meaning the company B bought A at $3mn.
3. To make the business more efficient over five years, Firm B invests $2mn in total over the 5-year period. Now, Company A generates $2mn in EBIT per year. The market believes it will continue to earn at least $2mn annually for the next seven years.
4. Another PE firm, C, wants to buy Company A and improve it further. It purchases Company A at 7X EBIT, or $14mn.
5. Bottom line: Firm B bought Company A at $3mn, invested $2mn, and sold at $14mn after five years. It made $9mn on its $5mn investment. The total return on investment is 180% or 22.9% per year over five years.

Understanding Multiples More Deeply

I used to think I fully understood the concept of multiples in business transactions. But after reading about a private equity firm called GSP, I grasped the full concept solidly (I think). One thing I learned was that the multiples more or less represent the future potential of a business.

• If a business is expected to lose market share due to increased competition, its multiple will be relatively low.
• If a business is expected to grow rapidly and capture a significant share of its total addressable market (TAM), its multiple will be relatively high.
• If a company is expected to maintain current earnings for at least N years, its multiple may be approximately N.

Is a Multiple Constant?

The nature of a multiple is not a fixed value. It fluctuates daily based on the likability of the business from the general public. Ben Graham once said that “the market is a voting machine in the short run.” If the business is favored enough – meaning people “vote” for it in the form of buying its stock – its so-called “value” (or, more accurately, its multiple) will shoot up, regardless of its actual earnings.

When a company’s the earnings remain the same but its stock price rises, the market capitalization increases, expanding the multiple.

A company’s market capitalization consists of two key parts:

1. Intrinsic value, which is justified through tangible factors like earnings, assets, liabilities, etc.
2. Speculative value, which is based on investor expectations and sentiment – in other words, hope.

The more people vote with high expectations, the higher the price. But as the saying goes,  “Higher the hope, the greater the disappointment.”

A company priced high due to investor speculation is highly susceptible to a massive price drop when negative news emerges. Investors who buy such stocks are, by default, vulnerable to sharp declines in their investment dollars.

Multiples From an Investor’s Perspective

The primary purpose of an investor is to generate positive returns on his capital. Investment decisions consider multiple factors, including:

• Past earnings record
• Future earnings potential
• Capitalization structure
• Industry competition

Based on these factors, an investor determines the fair value of the business. This fair value is often expressed as a multiple.

For example, after thorough analysis, an investor might conclude:

• “It’s fair to buy this company at anything below 7X EBIT.”
• “But anything above 7X EBIT is risky.”

If the business performs well, its multiple may expand beyond 7X EBIT, giving the investor an opportunity to sell for a profit. However, high multiples are susceptible to compression.

A prudent investor would avoid stocks trading at unjustified high multiple because who knows what will happen in the future? If negative news causes panic, the multiple can contract overnight and remain low for a long time – possibly longer than the investor’s holding period.

Thus, an investor should to be cognizant of what drives a company’s market price. If the stock price consists more of speculation than intrinsic value that is backed by tangible facts, it is wise to stay away. On the other hand, if the stock trades below intrinsic value, it may be an opportunity to buy. Why? Because by buying an undervalued stock limits the downside while leaving room for significant upside, which is a whole lot more preferable to buying an overvalued stock.

Multiples From a Business Seller’s Perspective

For business owners planning to sell their company and retire with a large sum, understanding the world of multiples is crucial.

Imagine you have spent years building a business, but now your hair is falling out, and your  dark circles are getting darker. What you want to do is to maximize the sale price.

To achieve this, your business should appear as attractive as possible to the potential buyers. The brighter the outlook, the better the multiple.

How do you increase the multiple?

You might want to fix up your business to increase operating leverage by reducing fixed costs, optimize operations to improve efficiency. You might want to secure long-term contracts to ensure stable and growing revenue.

Buyers will analyze financial reports before making an offer. If they see a well-structured business with predictable and increasing cash flows, they will bid aggressively for ownership. The higher the bid, the better off you are.

Although I haven’t started a business yet, but if I had one and I don’t plan to own it forever, I would carefully consider my exit strategy and the multiple I aim to sell for. In this case, investor speculation would work in my favor. 

All mistakes are mine.