The deeper you delve into enterprise capital, or equity investing in general, the more familiar you’ll turn out to be with the concept of “multiple” as a tool for quickly analyzing a company’s value.
However, there are divergent views on the role that multiples play in enterprise capital investment decisions. There has been a generational divide over the last decade, with a younger group of investors making the most of multiples more aggressively.
So what is the purpose of multipliers and how should investors use them?
First of all, let’s consider the origin: public markets.
When analyzing company shares on the public market, you have a wide selection of information at your disposal due to the related reporting requirements. When looking for alpha, investors will analyze multiples corresponding to EW/revenue, EV/EBITDA, EV/FCF Or P/E.
Each metric provides a barely different perspective on the share price performance and is used to grasp whether the company is currently undervalued by the market.
Multiples are also used to supply a broader understanding of public and private market trends. Here are two recent examples Marek Sistera conversation with Harry Stebbings about diagnosis inflated valuationsAND Bill Gurley, Brad Gerstner AND Aaron Levi we’re talking about the market software corporations.
In this second example, Gurley also comments on the modern use of revenue multiples, which we’ll discuss next: “Silicon Valley has the most primitive and least intelligent approach to valuation. They always rush when it comes to price-to-revenue because it’s easy and, frankly, it’s easy to be optimistic.”
Over the past decade, fueled by the rapid pace of deals in progress ZIRP, revenue multipliers got here to be understood as a shortened valuation tool. Theoretically, you would want to seek out a similar company that has recently raised capital, calculate its revenue multiple, and apply it to the other company’s revenue to find out a relative valuation.
It’s actually simpler than the typical pricing process, but does it work?
Basic problems
First, there is simply not enough data available in private markets. Finding similar corporations is a challenge; it is often almost not possible to get a good picture of their financial performance and the transaction terms that led to this valuation.
This is pro-cyclical. Relative valuations work well when prices of comparable corporations are based on some justification of intrinsic value. Unfortunately, pricing with multiples is so popular as of late (e.g 71% of European VCs), that there is a tenuous relationship between price and value, which makes enterprise capital more vulnerable to inflationary cycles.
This is the improper strategy to look at the outliers, which is essentially what enterprise capital relies on. Which did a lot Mistral AI use for seed round? What about On the sensor? The logic quickly breaks down when we glance at category-defining startups that investors should pursue.
They don’t actually calculate the valuation. Finally, a valuation with multiples could seem attractive for convenience reasons, but like a valuation based on goal properties, it is not actually a valuation. In fact, multiples are used to justify assigning a number that seems right (or invalidating a trade altogether) based on a roughly intuitive view of value. In most cases this is a lie.
The role that multipliers should play, as shown in the earlier examples, is to grasp trends and provide context.
Generally, this implies two things: comparing conditions with the broader market to see how the startup ranks in comparison with other corporations, or analyzing trends in the fundraising market more generally, corresponding to changes in expectations during and between stages.
Essentially, multiples are a tool for comparing and analyzing valuations, not a shortcut for calculating them. Imprecise comparisons that lack substance will proceed to generate bubbles, hurt returns and harm outliers.