How Do Analysts Adjust Market Multiples for Companies With Significant Debt?
Debt, if mismanaged, has the potential to become a destabilizing force capable of bringing down even the most powerful corporations. For instance, General Motors (GM), a prestigious American automobile company, had to file for bankruptcy after its debt became unmanageable. The company could only be rescued after its debt was reduced from $170 billion to $48 billion by swapping it for equity.
When reports merely suggested that GM might file for bankruptcy, its share price fell by 15% in premarket trading. Thus, we cannot discount the impact debt has on market perception. Hence, in this article, we will explore methods to adjust market valuation multiples for companies with significant debt.
Why is it important to account for debt levels in valuations?
A company’s debt level directly impacts its free cash flows to equity (FCFE) and, hence, is a key factor in determining valuations. To build some intuition about this, let us observe how a company’s valuation shifts with varying debt levels.
In this example, we will consider three cases where a company’s interest to EBIT ratio is 10%, 30%, and 50%. Its cash flows in the three cases can be summarized as follows.
| Particulars | Case 1 | Case 2 | Case 3 |
|---|---|---|---|
| Earnings before interest and taxes | $1,000,000 | $1,000,000 | $1,000,000 |
| (-) Interest | $100,000 | $300,000 | $500,000 |
| (-) Taxes (21%) | $189,000 | $147,000 | $105,000 |
| (+) Depreciation and amortization | $80,000 | $80,000 | $80,000 |
| (+) Change in working capital | $15,000 | $15,000 | $15,000 |
| Free cash flow to equity (FCFE) | $806,000 | $648,000 | $490,000 |
We shall make the following assumptions:
- EBIT growth rate: 15%
- Expected remaining lifespan of the company: 5 years
- Discount rate: 10%
- Constant depreciation and amortization
- No changes in working capital
- Constant interest payments
Our financial projections could then be visualized in the following manner.
We can see that there is a wide gap between the discounted cash flows of each year across the three scenarios. Notably, in 2025, Case 1’s discounted cash flow is 53.24% higher than that of Case 3. Thus, it is no surprise that the company valuations in these three cases have wide disparities.
Company valuations in all three cases:
| Case | Valuation | Valuation as a percentage of case 1 |
|---|---|---|
| 1 | $4,526,205.05 | 100.00% |
| 2 | $3,927,260.74 | 86.77% |
| 3 | $3,328,316.43 | 73.53% |
In this example, the company’s valuation dropped by 13.23% and 26.47% as the interest payments to EBIT ratio was adjusted from 10% to 30% and then 50%. However, you must note that we have also assumed constant interest payments.
A company that has significantly high debt levels may suffer an even greater reduction in valuation due to increasing interest payments with downgrades in credit ratings, and an increased risk of financial distress.
How to adjust market valuation multiples based on debt levels?
As we demonstrated in the previous example, debt levels directly impact valuations by reducing the FCFE. So, when we adjust market valuation multiples to account for debt levels, we must do so based on the EBIT/interest ratio. Specifically, we should divide the market valuation multiple by the market EBIT/interest ratio to arrive at the interest burden-adjusted market valuation multiple. Then, we can multiply this valuation multiple by the company’s revenue (in case of revenue-based multiples) and then by its EBIT/interest ratio.
Let us use an example to see how this works out in practice.
Suppose Voltforge Technologies, an electronics manufacturer, has an annualized revenue of $8 million and an EBIT/interest ratio of 31. We also know that the valuations, EBIT, interest payments, and annualized revenues of its peers are as follows.
| Company name | EBIT | Interest payments | Annualized revenue | Valuations |
|---|---|---|---|---|
| NanoCircuit Systems | $8,100,000 | $736,364 | $10,125,000 | $111,375,000 |
| Corelex Electronics | $7,100,000 | $355,000 | $8,165,000 | $146,970,000 |
| BlueArc Semiconductors | $6,000,000 | $176,471 | $7,560,000 | $151,200,000 |
| FusionGrid Manufacturing | $6,800,000 | $158,140 | $7,888,000 | $220,864,000 |
| PulseWave Industries | $4,000,000 | $137,931 | $4,760,000 | $123,760,000 |
| NextPhase Electronics | $3,800,000 | $200,000 | $4,598,000 | $114,950,000 |
| Quantelix Components | $7,000,000 | $318,182 | $8,190,000 | $139,230,000 |
| Aegis MicroTech | $2,000,000 | $57,143 | $2,300,000 | $55,200,000 |
| Silicore Solutions | $6,100,000 | $145,238 | $7,442,000 | $163,724,000 |
| EdgeVolt Devices | $4,800,000 | $177,778 | $6,096,000 | $146,304,000 |
Based on this information, we can calculate the market valuation multiple and the market EBIT/interest ratio.
Market valuation multiple = Sum of valuations of all companies ÷ Sum of annualized revenues of all companies
= $1,373,577,000 ÷ $67,124,000
≈ 20.46
Market EBIT/interest ratio = Sum of EBIT of all companies ÷ Sum of interest payments of all companies
= $55,700,000 ÷ $2,462,245
≈ 22.62
As mentioned earlier, we can now adjust market valuation multiples by dividing them by the market EBIT/interest ratio.
Interest burden-adjusted market valuation multiple = Market valuation multiple ÷ Market EBIT/interest ratio
= 20.46 ÷ 22.62
≈ 0.90
Multiplying the interest burden-adjusted market valuation multiple with Voltforge Technologies’ annualized revenue and EBIT/interest ratio, we can find its valuation.
Voltforge Technologies’ valuation = Debt-adjusted market valuation multiple × Voltforge Technologies’ annualized revenue × Voltforge Technologies’ EBIT/interest ratio
= 0.90 × $8 million × 31
= $224,338,076.39
In our example, we arrived at a valuation of $224 million for Voltforge Technologies. But if the company had significantly higher debt levels, we would arrive at a much lower valuation. For instance, at an EBIT/interest ratio of 12, we would arrive at a valuation of $86.84 million. Thus, this market valuation multiple adjustment method allows you to account for the impact of debt levels on cash flow.
Can this method be applied to all companies?
A major drawback of this method is the need for detailed financial data. Hence, it often cannot be applied to private corporations and startup valuations. In such situations, you could build an EBITDA-based market valuation multiple, apply it to the company being valued, and then adjust the valuation for the company’s debt burden. We can do so by modifying the adjusted present value (APV) method.
Let us use an example to see how this approach works.
Suppose ThriftNest is a discount retailer and its financial performance and outlook can be summarized as follows.
- Present EBITDA: $16 million
- Expected remaining lifespan: 5 years
- Present interest tax shield (Interest expense × Tax rate of 21%): $800,000
- Expected financial distress:
- Year 1: $80,000
- Year 2: $50,000
- Year 3: $20,000
- Year 4: $0
- Year 5: $0
- Discount rate: 12%
- No other financing effects
- No change in interest tax shield over the next 5 years
We also know that the EBITDAs and valuations of ThriftNest’s competitors are as follows.
| Company name | EBITDA | Valuations |
|---|---|---|
| ValueVault | $20,000,000 | $440,000,000 |
| SmartCart Deals | $17,000,000 | $255,000,000 |
| Cut Price Corner | $11,000,000 | $319,000,000 |
| The Discount Den | $10,000,000 | $110,000,000 |
| Frugal Finds | $20,000,000 | $360,000,000 |
| Deal Depot | $14,000,000 | $210,000,000 |
| LowCost Lane | $20,000,000 | $180,000,000 |
| Red Tag Retail | $22,000,000 | $220,000,000 |
| Everyday Essentials | $24,000,000 | $480,000,000 |
Once again, we will calculate the market valuation multiple.
Market valuation multiple = Sum of valuations of all companies ÷ Sum of EBITDAs of all companies
= $2,574,000,000 ÷ $158,000,000
≈ 16.29
Now, we will calculate the pre-adjustment valuation of ThriftNest.
ThriftNest’s pre-adjustment valuation = ThriftNest’s EBITDA × Market valuation multiple
= $16 million × 16.29
= $260,658,227.85
To adjust this valuation for ThriftNest’s debt, we must first calculate the present values of expected tax shields and financial distress.
| Particulars | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Tax shield | $800,000.00 | $800,000.00 | $800,000.00 | $800,000.00 | $800,000.00 |
| Present value of tax shield | $714,285.71 | $637,755.10 | $569,424.20 | $508,414.46 | $453,941.48 |
| Expected financial distress | $80,000.00 | $50,000.00 | $20,000.00 | $ - | $ - |
| Present value of financial distress | $71,428.57 | $39,859.69 | $14,235.60 | $ - | $ - |
Now, we can find ThriftNest’s valuation by adding the total present value of tax shields and subtracting the total present value of expected financial distress from its pre-adjustment valuation.
| ThriftNest's pre-adjustment valuation | $260,658,227.85 |
| (+) Present value of tax shield | $2,883,820.96 |
| (-) Present value of expected financial distress | $125,523.87 |
| ThriftNest's valuation | $263,416,524.94 |
In this case, ThriftNest’s valuation increased after adjusting for its debt structure. This occurs when a company has significant debt but manages it efficiently. If we valued a company that managed its debt poorly and was expecting severe financial distress in the future, its valuation would drop after the adjustment.
The adjusted present value method and the market valuation multiples can be used in tandem to accurately value companies with significant debt. A benefit of this valuation approach is that it does not punish companies for simply having debt. It reduces valuations only when there is significant financial distress, and good debt management is actually rewarded.
Eqvista- Ensuring compliance with accuracy!
In complex valuation scenarios, you cannot simply rely on the basic financial models and may need to adjust and combine valuation methods to suit the situation. This requires impeccable financial acumen, access to various kinds of data, and experience. In this article, we demonstrated how debt impacts valuations through cash flows and then explored ways to modify existing valuation methods to get accurate results.
At Eqvista, we face such complex scenarios regularly and thus have the ability to develop tailored valuation approaches that truly reflect business realities. This experience has positioned us as trusted valuation partners, whether for regulatory compliance, strategic investments, or funding negotiations. Contact us to learn more about our services!
