Moore, Ellrich & Neal P.A

The price-to-revenue multiplier is a popular valuation multiple, especially for service firms such as accounting practices or insurance companies. Mechanically, valuing a company using a price-to-revenue multiple is relatively straightforward (i.e. multiply the underlying revenue of the subject company by the revenue multiplier to derive an indication of value). However, proper application of the price-to-revenue multiplier is more complicated than the simple mathematics suggest, as profit margins have a significant theoretical impact on the size of the price-to-revenue multiplier.

In constructing the cost of equity capital, Duff & Phelps currently recommends that investors/valuation analysts use a 5.5% equity risk premium and a 4% normalized risk-free rate (i.e. a total cost of equity capital of 9.5%). The normalized risk free rate, which is based upon a long-term average rate, is used in place of the spot yield during those months in which Duff & Phelps believes the risk-free rate is artificially low (however that is determined). In my opinion, while the Duff & Phelps methodology develops an appropriate base cost of capital that is consistent with other metrics that I commonly rely upon, the concept of “normalizing” the risk free rate is problematic for two reasons. First, normalizing the risk free rate creates an “artificial” rate of return that is not available for investors to actually purchase. Second, normalizing the risk-free rate distorts the composition of investor’s future expectations of returns relative to other models.