The PE multiple valuation or PE ratio valuation technique can be used to provide a rough valuation of the equity of a business based on its earnings after interest, tax and depreciation.
The PE multiple valuation uses after interest, tax and depreciation earnings, and is therefore dependent on the financing and tax structure of the business. The valuation is relevant only to the equity holders in a business and assumes all debt and liabilities are taken over.
The PE multiple valuation calculation formula is given a follows:
The earnings before interest, tax and depreciation can be obtained from the financial statements of the business and, if using projected earnings, is the final line in the Financial Projections Template headed “Profit after tax”.
How do you work out which PE multiple to use?
The PE multiple valuation requires a PE multiple to be found for your business. Unless you have access to private industry data to see what similar businesses have sold for, it will be necessary to use PE multiples from listed companies and adjust these as necessary.
You should look for PE multiples for businesses in the same industry sector as your business using sources such as Google or Yahoo finance or the financial press.
Having found a suitable listed company PE ratio, adjustments will be necessary to allow for the fact that your business is a private (more risky, less liquid) company. As a rule of thumb, the PE ratio for a small private company should be half that of the PE ratio for a listed company in the same industry.
PE Multiple Valuation Example
The easiest way to show how PE multiple valuation works in practice is by using an example.
Suppose your business has earnings of 100,000, and a typical PE multiple for a listed company in your industry sector is 10.
The first step is to reduce the listed PE ratio to allow for the fact that the business is private and therefore less liquid and more risky, For simplicity we will assume that the PE ratio of the private company is half that of the similar listed company, so in this case the PE multiple is 10 / 2 = 5.
A rough estimate of the PE multiple valuation of the equity in the business is then given by:
PE multiple valuation = 5 x 100,000 = 500,000
What does the PE Multiple mean?
In the example above, the PE multiple was 5 and the PE multiple valuation turned out to be 500,000.
If you were buying this business, you would have paid 500,000 for a business generating annual profits of 100,000. This means that in 5 years time you will have recovered the money invested in the business, or looked at another way, it takes 5 years to get your money back.
If this level of earnings continues indefinitely, the annual return on your investment would be given by the formula:
Annual return = 1 / PE Multiple = 1 / 5 = 0.2 or 20%
So the PE ratio tells you how many years it will take to get your money back, and assuming the same level of profits indefinitely, 1 / PE multiple tells you the annual rate of return on your investment in the business.
It should be noted that the PE multiple valuation can only be used as a rough guide to the value of a business, the actual valuation will depend on numerous factors, and ultimately the business is worth what someone is prepared to pay for it.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.