Startup valuation is a tricky affair. Unlike mature businesses, early-stage startups don’t have any results to show in terms of profit. It takes time for an idea to mature into a profitable business. But this does not limit their need for investments. Growing startups need the right amount of funds to burn and support their exponential growth. For this purpose, company valuation is inevitable.
As we know, the easiest method to evaluate a company’s value in the market is by calculating the market cap. It gives a straightforward value and is a reliable metric since it directly involves its stock performance in the market. Higher the stock prices, better the market cap, and more profitable is the company in terms of return on investments. But in the case of early-stage startups, how does one determine the stock price? This is where startup valuation multiples find value.
What are valuation multiples in a startup?
In a startup valuation method, multiples basically compare one business metric with another and present it as a ratio. The most common of these compares an internal startup metric with the industry benchmark.
Investors use these ratios from various companies within an industry to compare which company would provide a better ROI. These multiples usually use three indicators – sales figures of a startup, earnings, or their assets, if any (rare for startups). Investors don’t rely on one particular valuation multiple. Different ratios are calculated and then compared as a whole before deciding on an investment opportunity.
These calculations are broadly categorized into three – current results vs growth rate, historical results vs forecast, and revenue vs profit. In the case of startups, since much of the reliable data is drawn from the present, using a ratio that compares current results with the growth rate is a dependable metric.
Why are Valuation Multiples Important in a Startup?
Startups operate in a highly competitive landscape. All are engaged in a game of profitable expansion. The factor that determines the worth of a new business is its value in the market. Thus, startups need a proper valuation from time to time.
This is inevitable because without a valuation, a startup:
- would not know if they are growing in the right direction
- would not know the exact worth of the business at any given time
- will not be able to approach investors for funding
- would not know their position in comparison to other players in the industry
- will not be able to track historical growth
Types of Valuation Multiples
Startup valuation multiples can be of various types. But primarily, they anchor around two functions – either the share price or the entire value of an enterprise. Here is how this works:
Valuation multiples that consider a company’s stock price are known as equity multiples. The current stock price is then compared to internal metrics such as the book value, earnings, or sales. Based on need, similar values beyond these three are also used. The most popular equity multiples are:
- Price-to-earnings ratio (P/E)
- Price-earnings to growth ratio (PEG)
- Price-to-book ratio (P/B)
- Price-to-sales ratio (P/S)
Enterprise Value Multiples
The types of valuation multiples that consider the entire value of an enterprise instead of only the stock price are known as enterprise value multiples. These give a more holistic view of a company as it accounts for all outstanding debts and variations in earnings as well. Some of the popular enterprise value multiples are:
- Enterprise value to sales ratio (EV/sales)
- Enterprise value to Earnings Before Interest and Taxes (EV/EBIT)
- Enterprise value to Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA)
Advantages and Disadvantages of Using Multiples
Using multiples for business valuation is, any day, a handy approach. But, like all metrics, they have their drawbacks too. It is not advisable to rely on only one multiple to deduce company valuations. Here are some of the pros and cons of using valuation multiples.
- They are easy to calculate as all data is available within the company metrics.
- They provide a relative value in comparison to industry benchmarks. It helps companies measure up their performance to industry standards
- They involve stats from the respective industries. This makes it easier for investors to verify data.
- They facilitate comparative forecasting of a company’s performance. It gives a peek into where a company could go in a few years.
- It is not enough to use one multiple. Analysts must compare many multiples to arrive at a realistic company valuation. This is an approximation technique and has to rely on an analyst’s experience and good judgment. This may be considered vague in the big scheme of things.
- All types of valuation multiples are dependent on relative industry benchmarks. There are chances of misleading an entire industry in case the foundations of these approximations are wrong.
Two Main Methods of Using Multiples
Now that we know a fair bit about multiples let’s explore the two main methods of using these multiples. Once an interested party, be it an investor or an acquirer, has a set of valuation multiples from prospective companies, how would they proceed with the decision-making process? Here are the two ways:
Comparable Company Analysis
To understand this approach, think from the point of view of an investor. If they invest in a startup with the sole aim of maximum profits, they would want to pay less and demand more returns.
Precedent M&A Transactions
This approach, on the other hand, looks back in time. Even with the present data of multiples, investors will look into historical data and analyze what other investors have paid for companies with a similar value of multiples. This approach can be seen as an enhancer to existing values in understanding trends and similar investor experiences.
Types of Startup Metrics
With these two distinct approaches in mind, here are the three types of startup metrics that form the foundation of different types of valuation multiples. Each one differs in their consideration of metrics of either the past or the present.
- Valuing Revenue vs Profit – Accounting for the revenue makes more sense for early-stage companies such as startups. But for mature companies, definitely, profit margins must be considered. Founders must make this important decision as to which type of metrics they would prefer to drive their multiples.
- Valuing Historical Results vs Forecasts – Historical results no doubt present authentic data. Stakeholders can see all details on paper. There is no need for any prejudices or procrastinations. But in the case of startups, there is no historical data available. But all the merit of a startup lies in its future growth potential. Thus multiples must be based on data that enable realistic forecasts.
- Current Results vs Growth Rate – Similar to the above approach, though current results present a realistic view of where the company is at the moment, it is limiting for startups. For an expanding business, it is only natural to base all valuation multiples on its growth rate.
How to Choose the Right Multiple to Value a Startup?
Multiples vary with industry as well as the type of markets within the same industry. Thus, it is not enough to simply have one value of a multiple. Different types of multiple values must be analyzed in the context of the type of industry and its segmented market types. The three most popular approaches are:
- Best fit – This is a convenient approach. If a startup is being sold, founders will choose a startup valuation multiple that would paint a good picture of the business. Similarly, if an investor is approaching a startup, they would seek companies with lower valuation with a potential for future success. Founders would present the business accordingly.
- Range, average, and weighted average – It is common practice to use many multiples and compare results. In this section, analysts could either consider a range of multiple values, an average of them all, or a weighted average. The entire point of this exercise is to accommodate all the values and make sense of the extensive data. Care must be taken in this approach so that multiples’ sheer volume and diversity don’t derail the evaluation context.
- Convention – One of the easiest ways to choose a multiple is to see what others are using in the same industry. This comes from an assumption of convenience and reliability. Alternatively, analysts could use either a statistical approach or by using a variable that highly correlates with the startup’s firm value.
How do multiples work in valuing the startup?
The first step to using a multiple is determining which startup metric it is based on. Every industry operates differently; thus, valuation experts must wisely choose the metric based on the target industry’s operating nature. Then, this business metric is multiplied with the valuation multiple to get a realistic value of a business.
Analysts must ensure that apples are compared to apples only and not oranges, no matter how ambitious a startup idea is. Industry-specific benchmarks are a reliable metric for startup valuations. Otherwise, a young, growing company does not have much to show, and any forecast at this stage is mostly words, and only time will determine its actual course.
Use different multiple methods for valuation of a startup
Multiples are a great way to analyze the bigger picture, the expected growth of startups, while they are still at a nascent stage. But there are different approaches. Multiples can’t be used ad-hoc as a simple, linear calculation. Here is a basic flow to this process:
- Determine forecast period – The first step is to analyze the period after which the company’s value is being determined. As in, from an investor’s perspective, how far into the future are they projecting a startup’s worth. For e.g., what would be the business value of a particular startup after 5yrs? This is the fundamental step as all projections and valuation metrics depend on it.
- Identify Peer Company – The next step is to identify the companies within the same industry who will be the peers with whom the startup will be compared. This selection is important as it depends not only on relative competition but also on companies following a similar business cycle as the startup. Some of the points of comparison are the company size, rate of growth, cash flow, operating margins, customer segments, etc.
- Determining correct price-to-earnings ratio – A price-to-earnings ratio is basically a value determined by dividing the current stock price of a company by its net profit. This ratio is an important indicator for choosing peer companies. The comparative list does not include those firms with P/E ratios differing too much.
- Determining current company value – Further, with all these benchmarks, the current company value can be determined by using the relevant startup valuation multiple.
Examples of Valuation Multiples
By now, you must have got the idea that valuation multiples are not a single entity. It should be viewed as a collective valuation tool that comprises multiple elements that give a holistic picture of a startup’s true financial worth when analyzed together. Here is a list of some of the commonly used multiples:
- P/E ratio = Share price / EPS
- Price/cash earnings = Share price / Earnings per share plus depreciation amortization and changes in non-cash provisions
- Price / Book ratio = Share price / Book value per share
- PEG ratio = Prospective PE ratio / Prospective average earnings growth
- Dividend yield = Dividend per share / share price
- Price / Sales = Share price / sales per share
- EV/ Sales = Enterprise value / net sales
- EV/EBITDAR = Enterprise value / Earnings before Interest, Tax, Depreciation & Amortization, and Rental Costs
- EV / EBITDA = Enterprise value / Earnings before Interest, Tax, Depreciation & Amortization
- EV/EBIT and EV/EBITA = Enterprise Value / Earnings before interest and taxes (and Amortization)
- EV/NOPLAT = Enterprise value / Net Operating Profit After Adjusted Tax
- EV/opFCF = Enterprise value / Operating Free Cash Flow
- EV/ Enterprise FCF = Enterprise value / Free cash flow
- EV/Invested Capital = Enterprise value / Invested capital
- EV/Capacity Measure = Depends on industry (e.g. EV/subscribers, EV/production capacity, EV/audience)
Want to know more about Valuation Multiples?
Valuation multiples form the core of the startup valuation process. It is not an easy task. As a founder, it is in your best interest to work with experienced professionals in choosing and analyzing data from various valuation multiples. Eqvista is a pioneer in this area. Our sophisticated equity management software ensures end-to-end equity distribution, and management and company valuation form the cornerstone of this expertise. Learn more about our range of services. For more information, reach us today.