Relative valuation – applying it in practice

When using relative valuation an analyst is going to take an average EBITDA multiple (determined through comparable company valuation), multiply by EBITDA of the company they are interested in, to arrive at debt free cash free value.

EBITDA multiple x EBITDA = DFCF valuation

Perhaps you can spot the consistency of thought here? EBITDA is an earnings figure that is before finance costs i.e. it excludes banks’ claims on the business – it’s pre-finance. Debt free cash free is the value of a company assuming banks’ claims were magically removed. It’s the value imagining the company had no debt. It’s a pre-finance value too. When using relative valuation in practice, what we are doing is taking a pre-finance multiple, applying that multiple to a pre-finance earnings steam (EBITDA) to arrive at a pre-finance debt free cash free value.

5 x 20 = 100

Image of a debt free cash free chart

Relative valuation: a simple example

Imagine we were trying to conduct relative valuation work for the company above. Imagine we had looked at the relationship of value/ EBITDA for a number of past transactions, as well as similar share-market listed companies, and reached the conclusion that a reasonable EBITDA multiple was 5x. Furthermore, imagine that the company above was generating 20 million of EBITDA. The average EBITDA multiple of 5, multiplied by 20, would yield a debt free cash free valuation of 100 million.

DFCF value minus net debt = shares/ equity valuation

In the chart above we have a route from debt free cash free valuation to equity or shares value (what the seller expects to receive). We could subtract net debt from the DFCF valuation to get to the value for the shares/ equity in the company. 100 million DFCF valuation minus 30 million net debt = 70 million shares/ equity valuation.

Relative valuation multiples: summary

This is not a full company valuation training course, but the essentials are laid out above. The most important point is that an EBITDA multiple x EBITDA = DFCF valuation. A buyer could conduct some research into valuation multiples other companies had sold at, or research into values other businesses were trading at in the share market, thereby obtaining an average multiple for comparable companies. The buyer might then apply that average multiple to EBITDA earnings for the company they were trying to analyse, helping them decide what their DFCF valuation should be. The bridge between DFCF and shares/ equity valuation is net debt, as per the chart above.

Continue with the valuation training course

Next the valuation course provides a very high level overview of another main valuation method: discounted cash flow or DCF valuation.