Therefore, we can delete the EV / EBITDA and P / E multiples from our PMO. Slack’s stock obviously doesn’t trade based on negative multiples. Some industry knowledge confirms this – growth SaaS businesses trade on forward revenue multiples. It should be noted that some types of companies almost always carry higher multiples than others. SaaS business are usually assigned much higher multiples than average contract manufacturing firms. But anyone can buy a company and increase its multiple by increasing its profitability and overall size.
Now you should understand what PIK interest is, why private equity professionals like it, and how to model it. This will be a quick post covering Payment-In-Kind (PIK) interest. PIK interest is a feature of some debt instruments that allows the interest expense to be accrued, rather than paid in cash, for a certain number of years.
Also, here’s another practice paper LBO based on a real modeling test. To learn more, check out our comprehensive (and free) private equity modeling course. Here, given you don’t have much information, and this is a highly illustrative example, I think it’s best to play it safe. A classic financing scenario for LBOs is ~50% senior secured bank debt and ~50% notes (or bonds).
What Is Multiple Expansion?
In our final step, we can compute the internal rate of return (IRR) and multiple of money (MoM) for each case. In our hypothetical transaction, the LBO target has generated $25mm in LTM EBITDA, which is the metric upon which the purchase multiple will be applied. The deposit multiplier is frequently confused with the money multiplier. Although the two terms are closely related, they are are distinctly different and not interchangeable. The deposit multiplier is also called the deposit expansion multiplier or the simple deposit multiplier.
The exact metrics and multiples we use will depend on the company’s financials. Pretty simple, we multiply the number of shares by the stock price. We’ll need (i) the stock price and (ii) the fully diluted share count. Next, we’re going to create a new tab for our public market overview (PMO).
The term is generally used for private equity, where a company buys a company and subsequently sells it at an increased price. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. In the five-year holding period during which the acquired LBO target belongs to the sponsor, half of its total debt financing is expected to be paid down.
Enterprise value (EV) is a popular performance metric used to calculate different types of multiples. EV shows how much money would be needed to buy a specific company. The EV of a company is calculated by taking the company’s market capitalization, adding total debt (including long-term and short-term debt), and subtracting all cash and cash equivalents. Many investors see EV as a better performance metric than relying on market capitalization alone because it offers a more complete picture of a company’s valuation. Private Equity provides probably one of the most extreme examples of multiple expansion in today’s markets and we have written a fair bit on this.
To answer this question, we’re going to return to our DCF template. Our template contains a switch (at the top) to vantage fx regulation turn on / off mid-year discounting. This switch will allow us to test the valuation impact of mid-year convention.
Organizations can begin using the product, and proving value, for free. At a certain point, they reach a paywall and must convert to paying customers. Therefore, the pool of free organizations forms Slack’s supply of potential customers.
While not a guarantee by any means, the odds of exiting at a higher multiple improves if the private equity firm is able to implement strategic adjustments such as the ones mentioned above. Once a financial sponsor acquires a company, the firm seeks to gradually pursue growth opportunities while identifying operational inefficiencies where improvements could be made. The multiple is useful for pinpointing companies that might be undervalued or overvalued. It’s best used for less capital-intensive companies, with fewer depreciation and amortization expenses.
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A sponsor uses debt so that they can buy the company with less of their own cash (equity). Over time, as the company pays down its debt, the equity value will grow as a percentage of the total enterprise value, thereby increasing the value of the sponsor’s investment. As the company pays down debt and improves its financial health, investor confidence increases, which can result in multiple expansion.
- If there are credit concerns, you might settle on a lower total debt figure.
- In our hypothetical transaction, the LBO target has generated $25mm in LTM EBITDA, which is the metric upon which the purchase multiple will be applied.
- We also have a comprehensive (and free!) private equity modeling course.
- While each equity waterfall is unique, it’s important to understand this concept, because it surprises many ex-bankers.
Rather than starting with the purchase price and calculating implied returns, you start with the required returns and calculate the maximum implied purchase price. Go back through our intermediate LBO template and see how much multiple expansion affects projected returns. This is the LBO template we used to prepare for private equity interviews. It is more sophisticated than any modeling test you’ll encounter.
Revenue and Earnings Growth
When potential buyers evaluate the possible profit potential of a company, they often mistakenly refer to multiple expansion as an independent variable. For example, one of them might say, “If we could just milk some multiple expansion out of this company, we could really clean up! ” However, dowmarkets this multiple is virtually always closely correlated with the profitability of the business in question. The private equity firm Dewey, Cheatem and Howe buys a transportation company for a total enterprise value of $50. At that point, the transportation company has $10 of LTM EBITDA.
What makes a good credit?
We do this, because Net Interest Expense reduces Net Income, but this portion of Net Interest Expense is a noncash expense. For the first 3 years, Noncash Interest Expense will be relatively high, because it includes the PIK Interest Expense. In practice, if your LBO model draws on the revolver at all, that’s cause for concern, and you likely need to reevaluate your assumptions. The revolver is a financing source of last resort, and you should not be drawing on it in your forecast. This means that the management team owns at least 10% of the existing equity and agrees to keep 10% invested alongside the sponsor. In interpretation, the ratio tells us how much investors are willing to pay for each dollar of earnings.
Understanding Where Investment Returns Come From: Yield, Growth, and Multiple Expansion
The multiple in this case would be 4, using the methods of calculation that we demonstrated previously. For now, all you need to know is that multiples represent values where one metric is divided by another (such as rice-to-earnings, P/E). These multiples can be compared between multiple companies to assess value and potential investment opportunities. In this article, you’ll learn what a multiple is, how to use it, and many instances where the term multiple expansion can be used. Multiple expansion is a form of arbitrage, which is a strategy for trading assets in different markets or derivative forms to take advantage of price differences.
Furthermore, many private equity firms have dedicated capital markets professionals, who provide guidance on financing assumptions and liaise with banks. To be frank, your interviewer probably wasn’t a capital markets banker and likely has a surface-level understanding of debt financing. Finding a rapidly growing company early is an important part of what’s needed for a multi bagger, but another critical element to multi-baggers is multiple expansion. This is where the value, or multiple, prescribed to a business, be it price to earnings, EV/earnings, price to sales, etc, expands as the company continues to grow in size. And it’s about understanding what drives this multiple expansion.
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