Valuation based on capitalization of earnings vs market multiples

July 07, 2021

by a searcher in Illinois, USA

Curious which valuation technique are used for what uses cases ? does one favors the seller better than the other ? When looking at the business values using capitalization method, as a buyer what should they be aware of / careful of ?

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Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

1) For simplicity, use market multiples and recognize there is a) a range on multiples. Typical std.. deviation is high. as an example, if EBITDA multiple is 5, Std. deviation is 2, meaning 70% of multiples are with 3 to 7. b) there is a lot of noise in SDE/EBITDA (when you see a business, do you agree with adj. profit? Which profit did the broker submit to database?, c) there is a lot of noise in what is included in price, and d) transaction structure is absent.
2) Consider, doing pro-forma financials to check your IRR at the price you are considering offering. This will be the acid test.
3) Capitalization: The Gordon Growth Model (GGM) uses WACC. Prof. Gordon developed DDM (Dividend Distribution Model) with no debt, Current GGM is an adaptation of DDM without any proof in any finance books (I would like someone in this elite SF community to help me find the proof). GGM assumes that the numerator is cash and it is distributed to debt and equity, that the numerator will grow at a constant rate for ever, and debt principal will never be repaid, if anything, it assumes that business will continue increase debt to keep WACC constant and such additional debt will be paid out as dividends. I have written articles on this. Capitalization (GGM) overvalues significantly (sometimes 90%).
4) Anyone suggesting using other than cash in GGM numerator is doing it wrong, does not matter what valuation certificate they have.
5) Capitalization 2.0: I have developed Advanced Growth Model (AGM) for calculating Terminal Value. You can download the formula spreadsheet free from www.AltBV.com. It compares AGM and GGM capitalization. DDM (GGM) derivation is few lines; AGM derivation is 20 pages. One of these days, I will release details.
6) WACC: Discounting with WACC is theoretically wrong (unless one assumes that debt principal will never be repaid). Have you seen any corporate finance book that has debt amortization and WACC together? They don't have debt amortization b/c Corporate Finance theory assumes efficient capital markets with no friction cost.
7) True DCF analysis should discount cash flows to each party in the transaction by its expected return to overcome WACC limitation, There is a ready made interactive valuation and structuring tool called BVX (www.BVXpress.com), developed by me. If you enter price, it will give you IRR. If you enter expected return, you will get value. What-if analysis of deal critical parameters is instantaneous. Users use BVX for live presentation to Boards, investors, banks, accountants, sellers and buyers. Zero ambiguity of BVX is due to its purest execution of finance and accounting theories. BVX has no market data and no industry input. After all. accounting and finance books are independent of company size and industry type.
8) I have offered BVX to Searchers free on a limited basis.
9) I hope to publish a book on DCF+, and a book on DFCF balance sheet one of these day. Hope they help overcome the legacy resistance to change.

Reply by an intermediary
from Universidade de São Paulo in São Paulo, State of São Paulo, Brazil

I read all excellent responses, and I would include an additional perspective related to the valuation and its consequence when dealing with the investor.. There are two ways to valuate the company: i) looking backward and ii) looking forward. If you are selling the past (looking backward) multiples based on indicators (EBIT, EBITDA, Dividends,....) may conduct you to a best approach to a negotiable agreement, and you can easily prove the numbers. The scope of your negotiation will be focused on the multiple. If you are selling a business plan (looking forward) probably the value reference comes from a DCF analysis and the result will be compared to similar transactions to check the investors apetite for the value. If you are selling a stake to a new equity holder and the preceedings will be integrally invested in the company you must confront the value of the company in the pre money scenario with the value of the company in the post money scenario (Several companies worth nealry zero without the money... and the value comes from the post money scenario) and decide the size of equity stake that will be offered to the investor and you will be responsible to reach the foresseen performance. If you are seling 100% of the equity you probably will be subjected to accept certain conditions related to the future results. In other words, you will take the risk the new equity holder will not perform and, consequently, will not pay the expected value.

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