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Leverage effect
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Growth effect
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Risk effect
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Here’s what else to consider
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Enterprise value multiples, such as EV/EBITDA or EV/FCF, are commonly used to compare the valuation of different companies or sectors. However, these multiples can be affected by various factors, such as leverage, growth, and risk, that may distort the true value of a business. In this article, you will learn how to account for these effects and adjust the enterprise value multiples accordingly.
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1 Leverage effect
Leverage refers to the use of debt to finance a business. It can have a positive or negative impact on the enterprise value multiples, depending on the cost and benefit of debt. On one hand, leverage can increase the enterprise value multiples by reducing the tax burden and enhancing the return on equity. On the other hand, leverage can decrease the enterprise value multiples by increasing the interest expense and the financial risk. To account for the leverage effect, you can either use unlevered multiples, such as EV/EBIT or EV/EBITDA, that exclude the interest expense, or use levered multiples, such as EV/FCF or EV/NI, that include the interest expense and adjust them for the optimal capital structure.
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2 Growth effect
Growth refers to the increase in the revenue or earnings of a business over time. It can have a positive or negative impact on the enterprise value multiples, depending on the sustainability and profitability of growth. On one hand, growth can increase the enterprise value multiples by generating more future cash flows and creating competitive advantages. On the other hand, growth can decrease the enterprise value multiples by requiring more capital investment and facing diminishing returns. To account for the growth effect, you can either use normalized multiples, such as EV/EBITDA or EV/FCF, that reflect the long-term growth potential, or use forward multiples, such as EV/EBITDA (FY+1) or EV/FCF (FY+1), that incorporate the expected growth rate.
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3 Risk effect
Risk refers to the uncertainty or variability of the future cash flows or earnings of a business. It can have a positive or negative impact on the enterprise value multiples, depending on the diversification and mitigation of risk. On one hand, risk can increase the enterprise value multiples by offering higher returns and opportunities for innovation. On the other hand, risk can decrease the enterprise value multiples by increasing the discount rate and the probability of failure. To account for the risk effect, you can either use adjusted multiples, such as EV/EBITDA (adj) or EV/FCF (adj), that factor in the risk premium or discount, or use comparable multiples, such as EV/EBITDA (peer) or EV/FCF (peer), that match the risk profile of the target company.
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4 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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