Valuation Multiples, Growth Rates, and Margins

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.
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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:
youtube-breakingintowallstreet...

[@user-jj6ro4mc8l]

Now, that's call analysis and understanding the deep correlation!! Amazing explanation, thank you..

[@financialmodeling]

Thanks for watching!

[@AkashGupta-tv8oj]

Awesome video. Thank you.

[@financialmodeling]

Thanks for watching!

[@cedricvongheer2853]

Great video with good content.

[@financialmodeling]

+Cedric Vongheer Thanks for watching!

[@kerrinnaude2777]

Thanks for the great video! Could you perhaps share how to calculate the Implied FCF terminal growth rate from EBITDA multiple?

[@financialmodeling]

It is covered in some of the DCF-related lessons on Terminal Multiples and Terminal Value.

[@DanielWeikert]

Great Video. Thank you. I d like to know which EBITDA Multiple is best to apply for Valuation? I have seen ttm Multiples as well as forward looking ones e.g. This business year is "1 quarter old" so they use the one "realized" quarter and a projection for the next 3 quarters to calculate EBITDA. It's a bit confusing.

[@financialmodeling]

There is no "best" multiple. You look at a wide variety of metrics and multiples from different time periods to get a sense of how much the company might be worth. You almost always look at one historical (LTM or TTM) multiple and one forward multiple, usually from the current year we're in.

[@christabane1974]

Thank you very much for the help that you provide us. Do you have some books that you would recommend us in order to go deeply in the subject?

[@financialmodeling]

+Christ Abane Check out any of the Wiley Finance books related to valuation or financial modeling.

[@Jeffrey0053]

Hi, that's a very helpful video I have a question, how do you estimate the FCF growth rate ? Is there any formula ? Thank you

[@financialmodeling]

No. It is usually linked to long-term GDP growth or inflation expectations. And then you cross-check it by calculating the implied multiple at various growth rates.

[@kmvkmv3433]

Hello Brian! Great video, thanks. For the purposes of Public Comps analysis, which sources of public available research analysis (i.e. future yrs growth) would you recommend?

[@financialmodeling]

+KMV KMV Look in equity research or find consensus estimates on Bloomberg or Yahoo Finance if you do not have access

[@vishaldahiya1222]

@@financialmodeling sir who to calculate fcf growth rate of 3 years please reply sir

[@shivkuma100]

Interesting point about two companies w/ different EBITDA margins, but similar multiples... Wont higher EBITDA margins give you a higher capacity for reinvestment, which when combined with high RoIC (or specifically high sales turnover) give you the growth potential ? In other words should you not be looking at EBITDA multiples in relation to EBITDA growth rate conjunction with ROIC (more specifically asset turnover component of ROIC) to explain ebitda multiples ? Per Damodaran's lectures - there are other factors like tax etc

[@financialmodeling]

I would not recommend thinking too much about this point. Valuation multiples are supposed to be simple - the more metrics you look at in conjunction with the multiple, the less useful the multiple is. To answer your question, yes, multiples depend on growth rates and RoIC, and higher growth rates and RoIC figures should result in higher multiples if everything else is similar. Our point here was simply that the companies you compare in a set of comps should have relatively similar margins (which often signal maturity and company stage) or else the comparison may not be that useful.

[@yoelherman5344]

Thanks a lot for the Video. Quick questions: (1)Can you clarify more in what way does a acquisition affect the EBITDA multiply or growth rate? in what way is the acquisition affecting the EBITDA? (2)why did you mention that the FCF is different then the EBITDA, in what way is it explaining the real life correlation between EBITDA growth and multiplies?

[@financialmodeling]

Your questions are beyond the scope of what we can answer in these free tutorials. Acquisitions could make a wide range of impacts on the multiples and growth rates depending on what the acquired companies look like; there is not one universal answer. A company's FCF might be declining even as its EBITDA is increasing (think about the definitions of both and included/excluded items), so the correlation is often very weak, even though, in theory, a multiple is "shorthand" for FCF, a growth rate, and a discount rate.

[@wenkaiyang1487]

Where can we get the discount rate for different industries? Are we getting it from any professional sources or calculate by ourselves? Are discount ｒａｔｅｓ conventional usually? In what situations, does one company have different discount rate than its peers in the same category?

[@financialmodeling]

We cover all these points in other tutorials in this channel if you look at the coverage of WACC and the risk-free rate. There are simple ways to approximate the Discount Rate for different industries. mergersandinquisitions.com/wacc-formula/

[@wenkaiyang1487]

another question: so you mentioned that 40% margin and 20% alone could mean the valuations are the same. does it mean if growth rate is the same, there is no difference in terms of investing into either of those companies even though one has higher margin than the other?

[@financialmodeling]

There is always a difference if the companies' financial profiles are different. The point here is that valuation multiples generally trend with growth rates, particularly with revenue multiples. You want a set of peer companies to have margins in a similar range for comparability purposes, but in most cases, companies with higher growth rates will tend to trade at higher multiples.

[@sanjayrathi457]

Could you please provide Excel sheet for the same...

[@financialmodeling]

+sanjay rathi The spreadsheet is not available for this one, but you can find similar examples in our channel and courses.

[@jagdagelet5591]

Would you know how we can get access to the excel file?

[@financialmodeling]

+Jag Dagelet There is no Excel file for this one because it's part of a more complicated model that is hard to separate out.

[@alexmagana7080]

Can you please explain why in this case increasing margins would lead to a higher EV/EBITDA multiple, but in another video you said larger margins would lead to a smaller EV/EBITDA multiple due to a larger denominator?

[@financialmodeling]

+Alex Magana The real takeaway is that growth rates, not margins, should determine multiples. The reason is that investors are willing to pay more for higher growth in the future. But a company with high margins doesn't necessarily mean anything - OK, great, they have a 40% profit margin, but how much are they *growing* by each year? A 40% margin is fine, but if there's minimal growth, investors won't pay more for that... because they can see the company already has a high margin and know exactly what they're getting. Valuation is all about future expectations, not what is already there. So with something like EV/EBITDA, the EBITDA growth rate should determine the multiple, or should at least have a good amount of correlation with it. Put differently, if two companies have the same discount rate and the same EBITDA, but one company is growing at 20% with a 15% margin and one is growing at 10% with a 25% margin, the 20% growth one would be valued more highly in most cases.

[@alexmagana7080]

Thanks for the clarification.

[@kanyuan6763]

Hi Brian, 13:20: You said "the terminal value is not affected by the margin" and I'm confused. The "growth rate" in the terminal value formula is the growth rate of FCF, not the growth rate of EBITDA. All else being equal (similar revenue, similar EBITDA, similar EBITDA growth rate), a company with 40% EBITDA margin will grow its FCF faster than a company with 20% EBITDA margin, resulting in the first company has a higher FCF growth rate. Although the EBITDA margin doesn't show up in the terminal value formula, it actually affects the FCF growth rate and thus affects the valuation multiple. So I don't quite get it when you said valuation multiples are mostly affected by growth rate but not margin. Can you elaborate a little bit more? Many thanks!

[@financialmodeling]

+Kan Yuan A company with higher margins won't grow EBITDA or FCF at a faster rate necessarily... a higher dollar amount, yes, but not a higher percentage, and these formulas all involve percentages. All that influences FCF growth is the company's revenue growth, and whether or not its margins / WC / CapEx requirements change. If those all stay in the same range, FCF growth will not change at all - try this in Excel and you'll see it firsthand. A higher margin alone doesn't mean that the *growth rate* will be higher - Microsoft is a higher-margin business than Salesforce, but is it growing at a faster rate? No, because it's also a more mature company and its revenue is growing at a slower rate.

[@Algoritmus_ai]

@@financialmodeling I agree with your Microsoft point, but in your example we're not analyzing a high margin alone, as you said to Microsoft. We're comparing two companies assuming they have the same size ( hence, same revenue), and same EBITDA margin growth rate. Once, they have same revenue, and one of them has higher EBITDA Margin, by definition it has Higher EBITDA. As you said in the introduction, higher EBITDA means higher FCF. Am I missing something? I'll be very thankful if you answer me.

[@financialmodeling]

@@Algoritmus_ai I am not sure what you're asking. Yes, if two companies have the same revenue but one has a higher EBITDA margin, its FCF will often be higher as well, meaning a higher valuation in a DCF. However, the growth rate is still relevant because the company's valuation depends on its FCF, Growth Rate, and Discount Rate. If the growth rates are very similar, the higher FCF will be more significant, but if the growth rates and FCFs are both quite different, it could go either way.

[@sonerguney3225]

Merci

[@financialmodeling]

Thanks for watching!

[@j.a.6866]

Can we get that excel file anywhere?

[@financialmodeling]

Not available for this video, but there are similar valuation Excel files throughout this channel.

[@TheMarinho1]

I have watch your video but still don't understand how it is possible that two companies (A and B) have the same EV/EBITDA Multiple (based on trading multiples) but Company B had a different DCF Valuation (based on Management Business plan). This question has come up in a corporate finance test. There were for answers: which one is correct? 1. Company B has a higher EBITDA margin than a company A 2. Company B's Management is more ambitious than market expectations for the industry 3. company A's sales are higher than company Bs. 4. Company A is planning less Capex but similar sales growth as Company B

[@financialmodeling]

The short/simple answer is that EV / EBITDA multiples measure only short-term performance and expected future results. But the DCF is based on much longer-term performance, such as what the company looks like in 5-10 years rather than 1-2 years, so it could easily produce a different valuation. Therefore, answer choice #2 here is probably the best one, though I would phrase it a bit differently (it's not really about "ambition" but about long-term expectations). Answer #4 would make sense only if Company A's DCF valuation were higher than Company B's.

[@andreaskuzma2839]

Are all of the videos also included in BIWS Premium? Thanks.

[@financialmodeling]

+Andreas Kuzma The videos in this channel are slightly different because they are more like "quick questions and answers" and not step-by-step tutorials. But you can access most of them in our Premium course now (we typically add the KZbin videos to an area within the course once or twice per year). But all the topics here are in the full course and are covered in more depth here.