A revenue or an EBITDA multiple is often seen as a hard-coded input to a valuation process. As much as we think that these multiples are pulled out of thin air, there is (usually) more method in the madness.
While a DCF is not used considering it is hard to build a financial forecast for a young company with no past data or with zero profitability, truth be told, even an EBITDA or revenue multiple valuation would require building a financial forecast as investors would like to know the exit options in 5 years. Though a multiples based method offers a simple heuristic to determine the value.
So, how are the multiples estimated?
Investors often invest in companies considering possible exit value of the company. If they have an internal mandate of getting an IRR of say 30%, they can work backwards from the exit value to calculate the entry multiple.
Let us look at an example:
Assuming both companies are in the same industry with the same initial revenue, we see that having different growth percentages can have a significant impact on the exit value and therefore on investor returns.
Company Apple has lower growth rates and a lower IRR than Orange. These companies should not have been valued at the same multiple at the time of investment.
If the IRR mandate was 30% over 4 years, assuming a 10x exit multiple, Company Apple should have been valued at $643 million, while Company Orange should have been valued at $2 billion since its exit is at $5.8 billion. Hence, an investor would be willing to pay a higher multiple in case of Company Orange.
So, while the management teams in both the companies would want to be valued at 10x, we can see that by looking at probability weighted exit scenarios, chances for investors for better returns in both companies are increased. A corollary for this is that at the right valuation, chances of funding for both these companies would increase.