When adopting the capitalisation of earnings methodology for valuing a business, a valuer must determine an appropriate multiple to apply to the future maintainable earnings of the business.
The earnings multiple is designed to be a measure of risk. It assesses the riskiness of the maintainable earnings of the business and is typically described as the rate of return an investor would require for a particular investment, when having regard to the inherent risks of the business.
Factors Affecting the Multiple
In forming a view on an appropriate multiple, it is common for an earnings-multiple to be influenced by:
- The rate of return on virtually risk-free investments;
- The trading history of the business and its historical performance;
- The business’ position in the market;
- Client relationships and the expertise of management; and
- The growth and strategic direction of the business.
When determining an appropriate earnings-multiple to adopt, valuers are typically guided by the following 3-Step process.
Step 1: Assess Multiples of Comparable Listed Entities
As a starting point, it is common for valuers to be guided by earnings multiples which are implicit with publicly listed entities which operate comparable businesses.
Depending on the size of the dataset being analysed, valuers may incorporate a number of comparable entities into their analysis for comparison and adopt either a median value from the dataset, or take a simple average approach.
It should be noted however, that earnings multiples of publicly listed entities are typically based on minority shareholdings which do not include a premium for control.
Step 2: Premium for Control Assessment
If the business is being valued on a control basis, an adjustment is generally made to account for a control premium.
A Premium for Control is a factor which is applicable to minority shareholdings which reflects the additional value that an acquirer of the publicly listed entity would be willing to pay, over and above the minority value.
Control premiums are intended to represent the benefits that would flow to an acquirer from gaining full control over the finances and operations of the target company, its ability to make decisions, appoint directors and influence the strategic direction of the company.
Step 3: Private Company Discount
When having regard to the implied multiples of private companies when compared to their publicly listed counterparts, it is common to apply a discount to take into account the following factors which affect the value of a private company operating in the same market:
- The business’ size, scale and access to key markets;
- Quality of infrastructure, systems and management teams;
- The level of dependency on key persons associated with the business and differences in key person risk; and
- Access to capital.
Conclusion
The determination of an appropriate earnings-multiple is a function of multiples which are applicable to comparable listed entities, adjusted for a Premium for Control, and discounted to reflect the limitations inherent in private enterprise.
Proper consideration needs to be given to appropriate earnings-multiples and it is crucial that valuers properly consider the characteristics of the business being valued when undertaking their assessment.
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