Price to Cashflow (or Proxies) - NPV and DCF

I think one of the most intuitive measures of value is cash flow in. The only problem with this valuation technique is that cash flow can often be erratic and unpredictable.

EBITDA can often be used as a proxy for cash flow either free cash flow to firm or free cash flow to equity (FCFF or FCFE). This is because managers can influence depreciation and amortization (which in turn affect income and therefore taxes). A normal EBITDA multiplier (enterprise multiple) to determine price is usually in the range of 3 to 7x. That means if your EBITDA is $50M per year, you might consider paying between $150M to $350M to acquire the asset (depending on various factors).

Enterprise Value = EBITDA x enterprise multiplier

In fact, it is these 'various factors' that I think warrant a closer look. After all, what would justify a higher multiplier for companies with identical EBITDA profiles?

I submit that your enterprise multiple is affected by different premiums. The top two that come to mind are business risk and liquidity. If the asset you are looking resides in an industry that generates cash flows irregularly or with a high degree of volatility (unpredictability) then you would expect the enterprise multiplier to drop (to compensate investors purchasing the asset with higher returns in the event of good cash flows).

Also, liquidty would be a factor regarding how well EBITDA acts as a proxy for real cash flow. This metric is much harder to quantify as it describes the reason why EBITDA is used as a proxy to begin with (probably because more accurate information is unavailable).

However, like any asset valuation technique, prices ranging beyond the standard range could be indicative of a few key points. Having assessed an asset's enterprise value being significantly below your EBITDA x enterprise multiple could indicate that the asset is currently undervalued. Conversely, being significantly above your EBITDA value implies that the asset is overvalued.

EBITDA is particularly valuable in M&A scenarios for private equity where public market prices do not exist. The black magic of this valuation technique is accurately projecting EBITDA into the future to determine the NPV using DCF. Particularly when modeling the life of an acquisition, enterprise multipliers can be applied to the terminal year of an asset (with appropriate assumptions) to determine the future exit price of an investment vehicle so an appropriate purchase price can be proposed using DCF.