Reading: Continuing Value using Multiples

Instead of modelling continuing value with a (growing) perpetuity, practitioners sometimes also use relative valuation (multiples) to estimate continuing value. For example, this approach could be useful in a situation where we assume that the firm in question will be sold after the forecast period.

To see how this approach works, suppose we want to apply an EV/EBITDA multiple to estimate continuing value. If so, we forecast EBITDA at the end of the forecast period and multiply that forecasted value times the industry's median forward EV/EBITDA value observed today. The following table illustrates the mechanics of that calculation.

 

• Free cash flows for the explicit forecast period of 5 years
• EBITDA for the first year of continuing value
• A forward EV/EBITDA multiple
• The firm's WACC.

 

Based on this information, we estimate the firm's continuing value using the EV/EBITDA multiple and combine the resulting valuation with the DCF valuation for the forecast period:

 

 

The table lists FCFs for the next five years as well as it's WACC of 12.8%. With this information, we can estimate the value of the explicit forecast period of 27'985. 

Moreover, for year six, we have forecasted the firm's EBITDA of 26'870. We also know that today's forward multiple is 6.9 (median industry value). Put differently, the market is willing to pay a value of USD 6.9 for each dollar of expected EBITDA. This allows us to estimate the firm's continuing value at the end of year 5

 

Hence, we can compute firm value as:

 

Clearly, this approach to estimate continuing value is much quicker than the steady-state valuation approach that we have discussed in the previous sections. However, it is also more susceptible to potential mistakes. As in all other applications of relative valuation, we have to make sure that the following applies:

• The comparable firms we use to estimate the valuation multiple (a multiple of 6.9 in the above example) are actually "comparable," in the sense that they have a similar business model, similar size, etc.
• The value indicator we use (EBITDA in the above example) is actually a value indicator that is relevant to the market.
• The valuation situation is comparable. For example, if we use multiples from exchange traded companies, we implicitly assume that our firm is also listed on an exchange and that the relevant transaction is that of minority shareholders dealing with each other. 

 

If the above conditions are not reasonably fulfilled, relative valuation will often produce a biased result. 

In addition to these "standard" challenges of relative valuation, there is an additional issue that arises in the context of continuing value estimation: 

• The multiples we observe (6.9 in the above example) reflect values the market is willing to pay today for current earnings (or expected earnings in 1 year). 
• There is no guarantee that this valuation multiple will be the same at the end of the explicit forecast period, which is usually much further in the future. In fact, as firms mature ( normal growth, margins, etc.) we would expect valuation multiples to come down, too. 
• The implication of this is that if we use relative valuation for continuing value estimation, we should at least measure the valuation multiples from a set of comparable firms that are currently as mature as we expect our firm to be at the end of the forecast period. Finding such firms is generally not an easy task.

 

In sum, this section has shown how to use relative valuation to estimate continuing value. It has also discussed the major challenges of this valuation approach. Since relative valuation is fairly easy to do, the recommended procedure is to do both valuation approaches: Steady state and relative valuation.