Valuation Multiples, Growth Rates, and Margins

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• published: 01 Sep 2015
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In this Valuation Multiples, Growth Rates, and Margins tutorial, you’ll learn about the relationship between valuation multiples such as EV / EBITDA and companies’ growth rates and margins, and you’ll see which factors influence the valuation multiples. http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers" Table of Contents: 3:11 Why Valuation Multiples are Shorthand for a Full DCF Analysis 14:06 Does This Correlation Hold Up in Real Life? 19:40 Recap and Summary Question that came in the other day… “I’m confused about how to interpret valuation multiples. If one company’s EV / EBITDA multiple is higher than another’s, does that mean it is growing more quickly? Or does that just mean its EBITDA margins are higher?” “In other words, are multiples more strongly correlated with growth rates or margins?” This is actually a tough question to answer, but the short answer is that valuation multiples are generally correlated with growth rates because multiples are “shorthand” for a full DCF analysis. So higher FCF growth implies a higher multiple: with higher growth, you could AFFORD to pay more for a company’s cash flows. Multiples: Shorthand for DCF Valuation Remember the formula for Terminal Value: Final Year FCF * (1 + FCF Growth Rate) / (Discount Rate – FCF Growth Rate). This implies that you can get a higher Terminal Value by boosting the FCF growth rate or by reducing the Discount Rate. But when you’re looking a set of comparable public companies, the Discount Rate *should* be about the same for all the companies in the set, since the risk/return profile will be similar for companies of a similar size in the same industry. So… in reality, it is mostly FCF growth that drives a company’s Terminal Value, implied value from a DCF, and therefore its implied valuation multiple(s) as well. What determines FCF and FCF growth? Revenue growth, operating margin, taxes, non-cash charges, Working Capital and CapEx requirements… …But the MAJOR drivers are revenue growth and operating margins (or EBITDA margins). When taken together, Revenue Growth and the Operating or EBITDA margin give you an indication of the company’s Operating Income Growth or EBITDA growth. If margins stay the same, revenue growth will flow down directly to EBITDA growth…. so a company growing revenue at 5% will see EBITDA growth of 5% if its EBITDA margin stays the same. If margins change, anything could happen. Increasing margins and holding revenue growth at the same level will result in FCF growth above revenue growth, for example. But the key point is that it’s NOT about the specific margin the company has – instead, it’s about how those margins are changing over time and how they’re influencing Operating Income or EBITDA growth. For example, a 40% EBITDA margin company and a 20% EBITDA margin company, if they’re growing EBITDA and FCF at about the same rates and they’re in the same industry with a similar size, should be valued at similar multiples. Why? Because investors are willing to pay more for more GROWTH, not more simply because a company currently has more free cash flow. Does This Correlation Hold Up in Real Life? Sometimes it does, but often it does not. For example, in our set of biotech/pharmaceutical comps, we get the following numbers: United: 10% EBITDA Growth, 7x EV / EBITDA Cubist: 14% EBITDA Growth, 21x EV / EBITDA Alexion: 22% EBITDA Growth, 23x EV / EBITDA JAZZ: 36% EBITDA Growth, 11x EV / EBITDA Salix: 41% EBITDA Growth, 10x EV / EBITDA MDCO: 137% EBITDA Growth, 9x EV / EBITDA These are off in real life because of the following factors: Acquisitions – These can distort the EBITDA growth figures and create misleadingly high numbers. EBITDA and FCF Differing Dramatically – They’re often quite far apart, so EBITDA growth doesn’t necessarily trend with FCF growth. Speculative Valuations – In markets like tech startups and biotech/pharmaceuticals, valuation is often highly speculative and linked to the results of clinical trials and so on rather than the pure fundamentals. Mispriced Asset – Or perhaps the company in question really is mispriced and the market is overvaluing it or undervaluing it. RESOURCES: http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-12-Valuation-Multiples-Growth-Rates-Margins-Slides.pdf