The private equity, venture capital, and the investment industry, in general, have adopted "earnings multiples" as the de facto valuation method for making a capital investment in businesses, whether public traded on the stock market or privately owned family businesses. The Canadian Economy thrives on the constant flow of capital being invested into companies as the driver of value creation. In this fourth installment of the Perspectives series, we explore and question the validity of the earnings multiples concept as an accurate method for evaluating the financial worth of a company, and what an investor should be willing to pay to acquire all or part of it. In particular, we look to answer three questions surrounding the earnings multiples method:
- Why are businesses valued at multiples of their earnings and what relevance is it to whether or not you, in reality, paid a good price for the company, or conversely, whether you sold at a good price?;
- Why are some businesses valued at three times earnings and some at 10 times? and
- Why are businesses valued on multiples of EBITDA in some cases and multiples of net income in others?