What Does
Multiple Expansion Mean?
Multiple expansion is a simple form of arbitrage that occurs when a buyer buys a company with a low entry valuation multiple and then turns around and sells it for a higher valuation multiple. The buyer is, therefore, buying low and selling high, just as those who trade securities in the open markets do.
The phrase “multiple expansion” can also refer to any type of increase in a given company’s valuation multiple. The initial investment is at a lower multiple because the company is smaller, has higher risk or a lack of process, but the exit is done at a higher multiple once the value creation strategy over the life of the investment has been executed.
An example of how this works can be seen in the following scenario:
The private equity firm Dewey, Cheatem and Howe buys a transportation company for a total enterprise value of $50. At that point, the transportation company has $10 of LTM EBITDA. Dewey, Cheatem & Howe, therefore, effectively paid a multiple of five times the TEV / LTM EBITDA multiple.
Now, the transportation company has grown to $20 of LTM EBITDA through organic methods and acquisitions. Dewey Cheatem & Howe sells the business for a total enterprise value of $140, which represents a 7x TEV/LTM EBIDTA multiple. Since the selling multiple was higher than the multiple at which the company was purchased, there was a multiple expansion of 2x.
Although it can be applied to just about any kind of purchase, multiple expansion is most commonly used in deals involving private equity. It is often paired with leverage and deal structure. It can be challenging to accurately predict the multiple expansion of a given company.
Most private equity firms, therefore, employ a range of special techniques geared toward increasing a company’s cash flow and operational efficiency. First, they use a disciplined approach to finding companies for sale with lower than average multiples. They then carefully monitor the current valuation multiples and other mergers and acquisitions deals happening in the market at that time. In the meantime, they to streamline company operations to increase the profitability of the company. Finally, they try to sell the company when the multiple expansion value is at its peak.
Multiple expansion is also known as the multiple effect or multiple arbitrage.
Divestopedia Explains Multiple Expansion
When potential buyers evaluate the possible profit potential of a company, they often mistakenly refer to multiple expansion as an independent variable. For example, one of them might say, “If we could just milk some multiple expansion out of this company, we could really clean up!” However, this multiple is virtually always closely correlated with the profitability of the business in question.
It should be noted that some types of companies almost always carry higher multiples than others. SaaS business are usually assigned much higher multiples than average contract manufacturing firms. But anyone can buy a company and increase its multiple by increasing its profitability and overall size. Buyers who know how to run certain types of companies profitably can make a living buying companies in their sector and improving their cash flow and operations and then resell them, thus achieving multiple expansion.
Here are “best in class” value creation techniques that private owners should consider in their own companies well before selling or partnering with a PE firm:
- Follow a disciplined approach to buying companies at lower multiples.
- Drive operational efficiency and free cash flow generation during the life of the investment.
- Constantly monitor current valuation multiples and industry M&A activity.
- Proactively seek the best timing to exit the investment at the highest multiple.