What this evaluation provides
- A frame to derive exit multiples from long-term growth, return and discount assumptions embedded in discounted money flow (DCF) models.
- Empirical evidence This expected growth explains much of the variation in observed multiples for high-growth corporations.
- Recognize that Interest rate regimes have a big impact on valuation levels and must be reflected in exit assumptions.
When valuing high-growth corporations, end assumptions (exit assumptions) often make up a big portion of the corporate’s value. If exit multiples are chosen without explicit reference to growth, return and rate of interest expectations, the evaluation can grow to be internally inconsistent. The following framework draws on valuation theory and empirical evidence to point out how exit multipliers will be derived from and consistent with underlying economic assumptions.
The limits of the five-year forecast
An ordinary income approach that uses an explicit five-year forecast plus a Gordon growth end point assumes the corporate achieves “stable growth” by the fifth yr. This is unrealistic for a lot of smaller, early-stage growth corporations. The high growth phase can last well beyond five years. One solution is to make use of two-stage or three-stage (or H-model) structures. However, in practice, many corporations’ business plans end within the fifth yr, and forecasting one other five years is commonly too difficult.
Therefore, many appraisers use an exit multiple based on EBITDA or sales. This approach is market consistent but combines relative valuation with an income-based framework.
Yes, we all know this will not be ideal. Mixing approaches is flawed in theory, but stays common practice, particularly within the private equity world.
The value driver identity as a bridge
A useful bridge is the worth driver identity, which links terminal value to ROIC, growth and discount rate. From a business perspective:
Divide by EBIT (or sales) to get an implied EV/EBIT (or EV/sales) multiple that’s consistent with the corporate’s long-term economics.
These are approximations, but they link the exit multiple to the assumptions about long-term growth (g), WACC, ROIC, margins and taxes.
Appraisers should then compare their exit multiple assumption with current medians, long-term sector bands and transaction evidence. If the comparative values ​​differ, appraisers can explain why; Differences in growth duration, capital intensity or risk.
In reality, the number of the multiple is predicated on the median or average of current valuations on the time of research or the typical of the median over the past five to 10 years. But is that right?
Well, as at all times – it depends. It is. Data teaches us something vital that we should always consider when selecting the exit multiple.
For exit EBITDA multiples: Michael Mauboussin found that expected EBITDA growth and the spread between ROIC and WACC have a big impact on the valuation of unprofitable corporations. However, determining the ROIC or exit EBITDA margin is difficult when corporations aren’t yet profitable or are in a stable phase.
For this reason, sales growth and gross margin are sometimes used as an alternative.
What the information shows
To further explore this relationship, we examined publicly traded operators across all industries within the US, Canada, and Europe and chosen only those with a 10-year CAGR above 30%, which we use as a proxy for growth-stage corporations. The evaluation covers the period between 2015 and 2024. For every year, we ran a regression with the LTM EV/sales multiple because the dependent variable and the expected 1-year sales growth rate because the independent variable (adding ROIC or gross profit margin as a second independent variable within the regressions, as expected, didn’t prove statistically significant since these corporations aren’t yet within the stable phase).
We observed two key findings:
- Expected one-year growth explains about 55% of the variation in valuation multiples.
- The intercept of every year’s regression is negatively correlated with the corresponding risk-free rate of interest. This is intuitive because high-growth corporations’ money flows (i.e. value) are focused on the long run, making their valuations more sensitive to the risk-free rate.
Authors’ evaluation
The second point highlights one other vital aspect when selecting an exit multiplier: it might be vital to form an opinion concerning the level of the risk-free rate on the time of exit. The prevailing rate of interest environment will influence whether the assumed multiplier is realistic and will be supported.
Diploma
Based on data and experience, investors, analysts and valuation specialists should avoid simply applying a median multiple in the ultimate exit yr. Instead, they need to consider expected growth beyond the top yr and form an opinion concerning the likely level of the risk-free rate. Everyone would really like to return to the low rates of interest of 2020-2021 with sky-high valuations, but that’s unlikely. Using the typical over the past five or ten years could lead to high valuations for today’s environment.
Three insights for practitioners
- Exit multiples aren’t plug numbers. They reflect assumptions about long-term growth, returns on capital and the price of capital included within the DCF.
- Growth expectations largely determine valuation differences. For high-growth corporations, higher expected sales growth results in higher observed multiples.
- Interest rates are vital. The level of the risk-free rate of interest has a big impact on valuation levels and must be taken under consideration when choosing an exit multiple.
