The Concept of Multiples Expansion: How Most Private Equity Works

Private equity firm PE Partners has decided to acquire Startup Inc. PE Partners is willing to employ multiple expansion to profit from its investment in Startup Inc. Currently, Startup Inc. has an Enterprise Value (EV) of $10 million and an EBITDA of $5 million. PE Partners has determined that EV/EBITDA is the most appropriate valuation multiple for the multiple expansion indications.

In a nutshell, yield is like the interest on your savings account or the bonus you get for investing wisely. Unlike the RRSP, you can withdraw money at any time without tax consequences. This makes it an excellent tool not just for retirement, but for any savings goal. The Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP) allow you to borrow from your RRSP for a home purchase or to fund education, respectively, without immediate tax consequences. In fact, the current situation may be one we look back at as a dream scenario.

What Is Multiple Expansion in Stocks?

The earnings per share have doubled from 10p to 20p, while the price/earnings ratio stays the same, at ten times before and after.
One key concept that plays a significant role in stock price appreciation is multiple expansion.
This gradual increase in contributions will result in higher benefits for future retirees.
Simply put, the objective behind multiple expansion is to “buy low, sell high”.
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.

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But the real game-changer came in 1957 with the birth of the RRSP. This revolutionary account allowed Canadians to save for retirement while enjoying sweet tax benefits. As if that wasn’t enough, in 2009, the government introduced the TFSA, adding another powerful tool to our retirement toolbox. As we’ve highlighted previously, revenue and earnings growth tell us that a company is on the right track. At the same time, don’t assume that a company trading at a high multiple has less growth potential than one trading at a low. A valuation multiple is a ratio used to evaluate the relative value of a company.

Stay informed with the latest trends and tools to empower your financial journey. FinancialFocusHub.com is your gateway to insightful financial guidance and strategies. My manager sat me down and explained why we were buying it in 1999 in the middle of a dot com boom. Hornby had realised they could move all their manufacturing to the Far East and significantly drop their operating costs. My boss theorised that a lot of people were moving into retirement and were very nostalgic for the Hornby brand. So if costs could be cut, sales and profits should go up, and the shares could rerate.

Let’s consider an investor named Andrew, who purchased 100 shares of Microsoft, a tech giant, five years ago. Each share cost $50 at that time, resulting in a $5,000 initial investment. In the world of investments, growth refers to the increase in the value of an asset over time. Growth, in the context of investments, is not just about plants or the economy—it’s a key driver behind the rise in the value of your investments. Regarding investing, one of the fundamental concepts that can greatly impact your returns is growth.

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If this enhanced EBITDA trades at the same multiple, the new valuation would be $120 million. Consider a private equity firm that buys several smaller companies, each generating $1 million in EBITDA. Individually, these companies might sell for six times their EBITDA, equating to a $6 million valuation each. If the firm acquires ten such companies, they would collectively generate $10 million in EBITDA. However, a single company with $10 million in EBITDA might sell for ten times its EBITDA, resulting in a $100 million valuation for the aggregated entity. Multiple expansion is a form of arbitrage that employs the purchase of a security at a lower valuation multiple and selling a security at a higher valuation multiple.

While many sectors are well off the highs experienced several years back, we’re also seeing a trend reversal where smallcaps are presenting strong value, with enormous potential for multiple expansion. Just as important, high revenue growth with earnings (profit) growth increases the chances that a company, and its growth, is self-sustaining. Investors should be aware of the factors that drive multiple expansion and monitor market conditions closely to assess whether the stock’s valuation is justified. By understanding the dynamics of multiple expansion, investors can make more informed decisions and navigate the complexities of stock valuation effectively. Multiple expansion can occur without any underlying growth in earnings. For example, a company that is trading at a P/E ratio of 10 and grows its earnings by 10% annually may see its stock price increase by 10% each year.

What is Multiple Expansion?

The most common multiple is the Price-to-Earnings (P/E) ratio, but other ratios like Price-to-Sales (P/S), Price-to-Book (P/B), or Enterprise Value-to-EBITDA (EV/EBITDA) are also used. Keep this strategy in mind as you contemplate your next steps in selling your business. Understanding how private equity operates can give you a significant advantage, allowing you to make informed decisions and achieve the best outcomes for your business. From the exercise we just completed, we can see the extent of how sensitive the returns on n LBO investment are to the purchase multiple and exit multiple. For instance, let’s say that a financial sponsor acquires a company for 7.0x EBITDA. If the target company’s last twelve months (LTM) EBITDA is $10mm as of the purchase date, then the purchase enterprise value is $70mm.

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However, if the P/E ratio increases from 10 to 15 during the same period, the stock price will rise much more rapidly, even without a significant change in earnings. As you can see, Multiple Expansion is a very powerful force on share prices. Potential multibaggers often start on moderate P/E ratios, which creates significant potential for the ratio to expand.

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This strategy involves careful integration and realization of synergies to maximize value.
While multiple expansion occurs when the valuation multiple of a stock increases, multiple compression happens when the valuation multiple decreases.
Consider your pension as part of your overall retirement income strategy.
By multiplying our LTM EBITDA by the purchase multiple, we can calculate the purchase enterprise value – i.e. the total purchase price paid to acquire the company.
Multiple expansion refers to an increase in the valuation multiples of an asset, such as a stock or a company.

Also, companies that make products for the electrical grid and telecommunications equipment are seeing very solid strength. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. In our final step, we can compute the internal rate of return (IRR) and multiple of money (MoM) for each case. On the date of exit, there should be $75mm in debt remaining on the balance sheet of the company.

As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. After three years, the company’s EV reaches $100 million and EBITDA becomes $20 million. In three years, Startup Inc.’s multiple has expanded by 2.5 times. PE Partners then decides to sell Startup Inc. to profit from its initial investment.

Although multiple expansion can be related to any type of purchase, this concept is widely used in private equity deals. Here, we’re assuming that the total leverage ratio was 6.0x LTM EBITDA and there are no other providers of capital other than the single leverage provider (i.e. debt-holder) and the financial sponsor. Since the purchase multiple was 10.0x, we can deduce the sponsor equity contribution was 4.0x LTM EBITDA (i.e. four turns of EBITDA).

Understanding these interconnected dynamics can help investors make informed decisions and navigate the complex investing world more effectively. While tech is currently out of favour, we are seeing growing interest in the companies that make the boring things nobody thinks about—in other words, the blue collar trade. Think cardboard boxes, rubber products, metal contraptions, and things that hurt if you drop them on your foot.

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