How valuers choose a capitalisation multiple

The short answer, explained

The capitalisation of earnings method values a business by multiplying its maintainable earnings by a multiple. The multiple is not a free-standing number. It is the inverse of a capitalisation rate, and the capitalisation rate is, in simple terms, the annual return a buyer would require from the business less the long-term growth they expect in its earnings.

That link is what makes a multiple explainable. A higher multiple means a buyer would accept a lower return, which is only reasonable if the earnings are more secure or expected to grow. A lower multiple means the buyer needs a higher return to compensate for more risk. When a client or another adviser asks why a report used a particular multiple, the answer should trace back to evidence and to specific features of the business, not to a rule of thumb.

The ATO's guide to market valuation for tax purposes lists, among the issues it commonly sees on review, a lack of support for size, risk and other adjustments to the chosen discount rate or capitalisation multiple, and an inappropriate choice of comparable assets. The guide also highly recommends a secondary or cross-check method. Those points apply well beyond tax work.

Step 1: confirm what the multiple is applied to

Before testing the multiple, check the earnings. A multiple only has meaning alongside the earnings measure it is applied to.

ASIC's guidance on expert reports (RG 111.86(b)) lists, among the methodologies it is generally appropriate for an expert to consider, applying earnings multiples appropriate to the business or industry to the estimated future maintainable earnings or cash flows of the entity, added to the estimated realisable value of any surplus assets. The same structure is used in private business valuations.

Step 2: identify the evidence for a range

Valuers typically draw on one or more of the following, and a report should say which and why.

• Completed transactions. Sales of comparable businesses where the price, the earnings and the terms are known. These are the most direct evidence when they exist, but private sale data is often incomplete, and the businesses sold may differ in size, location and what was included. Our guide to completed sales, asking prices and valuation opinions explains which kinds of figure count as evidence.
• Listed company data. Share prices and earnings of listed companies in a similar industry. These are observable, but listed companies are usually far larger, more diversified and more liquid than a private business, so a valuer who uses them must explain the adjustment made for those differences. Commercial databases that supply this data have their own licence terms.
• A build-up of the required return. A risk-free rate, such as the government bond yields published by the Reserve Bank of Australia in its statistical tables, plus premiums for equity risk, size and risks specific to the business. The result is converted to a capitalisation rate by deducting expected long-term growth, then inverted to give a multiple. That multiple applies to the cash flow measure the return was built for, usually after-tax cash flow after capital spending, so it must be translated before it is compared with an EBITDA or EBIT multiple. Each premium is a judgement and needs reasons.
• Cross-checks. A net assets figure, a discounted cash flow, or the implied payback period can reveal whether a multiple is out of line with the business's assets or prospects.

None of these sources produces a single correct figure. Together they set a range that a reader can follow.

Step 3: place the business within the range

This is where most disputes arise. The table below sets out the factors a valuer typically examines and the direction each pushes the multiple. It deliberately contains no figures: the size of each effect depends on the business, the evidence and the purpose of the valuation.

A report that is easy to defend shows this reasoning in a few sentences per factor, and states where in the evidenced range the chosen multiple sits and why.

Worked example: a hypothetical multiple and its sensitivity

This example is hypothetical. The rates, growth and multiples are round numbers chosen to show the arithmetic. They are not evidence of the multiple for any industry or business.

From a required return to a multiple. Assume a valuer concludes that a buyer would require a return of 30% a year from a business, and that its earnings can be expected to grow by 5% a year over the long term.

Check: 30% less 5% is 25%, and 1 divided by 0.25 is 4.0. Strictly, a growth-adjusted capitalisation rate is applied to the next year's earnings; valuers state whether they apply the multiple to current or expected earnings.

Sensitivity. Separately, assume maintainable EBITDA of $500,000 and evidence that supports a range of multiples from 3.0 to 4.0.

Check: $500,000 x 3.0 is $1,500,000; $500,000 x 3.5 is $1,750,000; $500,000 x 4.0 is $2,000,000. Each half step in the multiple moves the value by $250,000 ($1,750,000 less $1,500,000). Implied rates: 1 / 3.0 is 33.3%, 1 / 3.5 is 28.6%, 1 / 4.0 is 25.0%.

The point of the example is the $500,000 spread between the ends of the range. The choice of 3.0, 3.5 or 4.0 has to be explained by the factors in step 3, such as the customer base and the owner's role. If the explanation is missing, a reader cannot tell whether the multiple was reasoned or simply selected. You can run your own figures through the capitalised earnings sensitivity table.

What to ask when a report's multiple is questioned

• Which earnings measure is the multiple applied to, and is the evidence on the same basis?
• What evidence set the range, and how comparable is it?
• What adjustments were made for size and liquidity when listed company data was used?
• Which specific risks placed the multiple where it sits in the range?
• What cross-check was performed, and does it support the result?
• What capitalisation rate does the multiple imply, and, after allowing for tax, capital spending and the earnings measure used, is that return plausible for a buyer of this business?

For a broader review checklist, see how to review a valuation report prepared for the other side.

Limitations

• The capitalisation method suits businesses with stable, maintainable earnings. Where earnings are volatile, negative or expected to change sharply, another method may be more appropriate; see valuing a business with negative or volatile earnings.
• The relationship between a required return, growth and a multiple is shown here in its simplest form. Valuations may also consider tax, capital spending and the difference between earnings and cash flow.
• Industry multiples quoted in articles, broker listings or software are not evidence in themselves. This page does not publish or endorse any multiple.
• The appropriate basis of value, and whether any premium or discount applies to a particular holding, depends on the purpose and instructions of the valuation.
• This page is general information, not advice on any particular valuation.

Next steps

• Identify the earnings measure and basis the report uses, and confirm the multiple's evidence is on the same basis.
• Ask the valuer, or check the report, for the evidence that set the range and the reasons for the point chosen.
• Test how much the value moves across the range with the capitalised earnings sensitivity table.
• Make sure the earnings themselves are normalised and evidenced, using the earnings normalisation worksheet.

General educational information, not financial, tax or legal advice. Worked examples are hypothetical and do not value a real business. A valuation depends on its purpose, the evidence and the agreed scope.