Referenced from the Word Press Blog BV Insight. Please see www.BVInsight.wordpress.com for additional insight on Business Valuation.
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.
To understand this concept, let’s first begin with the basic formula for valuing a business:
Price = EBIT*(1-T)*P / (Kw-G)
Where:
EBIT = Earnings before interest and tax (next year)
T = Effective corporate tax rate
P = Free cash flow payout ratio (i.e. after-tax free cash flow as % of after-tax EBIT)
Kw = Weighted average cost of capital
G = Long-term sustainable growth rate
This formula is effectively the Gordon Growth Model using after-tax free cash flow instead of dividends. The valuation formula essentially equates the value of a business to the present value of its expected after-tax cash flows. Dividing both sides by Revenue we discover that the price-to-revenue multiplier is simply:
Price / Revenue = EBIT*(1-t)*p/(Revenue*(Kw-g))
Notice, that EBIT*(1-t)/Revenue is the after-tax profit margin of a business. Therefore, defining this variable as M, the equation above simplifies to the following:
Price / Revenue = M*p/(Kw-G)
Where:
M = After-tax profit margin (next year)
p = Free cash flow payout ratio
Kw = Weighted Average Cost of Capital
G = Long-Term Growth
This formula indicates that the price-to-revenue multiplier is influenced by the following factors:
1. After-Tax Profit Margin
2. Free cash flow payout ratio
3. Weighted Average Cost of Capital
4. Long-Term Expected Growth
Factors 2-4 essentially impact every valuation multiple. Factor 1 (i.e. after-tax profit margin), however, is a variable that is unique to the price-to-revenue multiplier. In effect, the after-tax profit margin is the theoretical fundamental variable that drives the variation in price-to-revenue multiplies, holding all else constant. The formula shows that a firm with a high after-tax profit margin will command a higher price-to-revenue multiplier than that of a firm with a low-after-tax profit margin.
By way of example, consider a firm that is expected to generate an after-tax profit margin of 15%. The free cash flow payout ratio is 50%. The cost of capital is 10% and the expected long-term growth rate is 5%. Under these assumptions, a price-to-revenue multiplier is computed as follows:
Price-to-revenue = 15%*50%/(10%-5%) = 1.5x
Now, consider a firm that generates 10% after-tax profit margin. Under these assumptions, the price-to revenue multiplier is computed as follows:*
Price-to-Revenue = 10%*50%/(10%-5%) = 1.0x
As one can see, the price-to-revenue multiple is lower in the second example due to the company’s lower after-tax profit margin. In fact, since risk and growth are the same, the entire differential can be explained by the ratio of profit margins (i.e. 1.5x * ( 10%/15%) = 1.0x)
Since after-tax profit margins influence the price-to-revenue multiplier, appraisers should be cognizant of differences in after-tax profit margins when relying upon them in the market approach. For example, suppose the appraiser generates a sample of market transactions with a median price-to-revenue multiplier of 2.0x. The appraiser also notes that the median after-tax profit margin of the underlying companies is 10%. The appraiser is now valuing a similar business, whose profit margin is only 5%. This business generates $10 million in sales. If the appraiser relied upon the sample of transactions without adjustment the appraiser would value the company at $20 million (i.e. 2.0x * $10 million). However, this would overvalue the subject company due to differences in after-tax profit margins. In fact, assuming the risk and long-term growth of the businesses was comparable, the appropriate price-to-revenue multiple for the subject business is actually 1.0x sales (i.e. 2.0x*5%/10%) due to its lower profit margin. Therefore, the correct value for this business is $10 million vs. the $20 million that one would obtain relying upon the unadjusted price-to-revenue multiples of the guidelines. The discrepancy is entirely attributable to differences in the after-tax profit margin.
This article demonstrates that the price-to-revenue multiple is influenced by the after-tax profit margin. In particular, a firm with a high after-tax profit margin will command a higher price-to-revenue multiple than that of a firm with a low after-tax profit margin, holding all else constant. If appraisers utilize price-to-revenue multipliers in the valuation of a business, they should focus on differences in the profit margin. If significant differences exist, then appropriate adjustment should be made to the multiples in order to derive a proper estimate of value, as failure to adjust the multiple for differences in profit-margins can lead to an erroneous conclusions of value.
*Theoretically speaking, the adjustment would be even greater than that described above because a lower-after profit margin, holding all else constant, would lower the return on equity and, therefore, the long-term sustainable growth rate of the business. I have assumed for illustrative purposes that the reduction in profit margin would be offset by improvements in asset efficiency such that the long-term growth rate would remain unchanged. If this assumption is violated than the appraiser should adjust the multiple for differences in growth as well.
- Joshua B. Angell, Valuation Analyst at Moore, Ellrich & Neal, P.A.
Referenced from the Word Press Blog BV Insight. Please see www.BVInsight.wordpress.com for additional insight on Business Valuation.