Forward Multiple

How to Calculate Forward Multiple?

The forward multiple is most often used to determine the valuation of a high growth company that is either unprofitable as of the present date, or the market is valuing the company based on its expected earnings in the future.

Given this context, it can be reasonable – or sometimes the only choice – to value a high-growth, unprofitable company based on its expected future profitability as opposed to its actual historical performance.

• Unprofitable (or Limited Profitability): If a company is currently unprofitable, usage of traditional valuation multiples, such as EV/EBITDA and EV/EBIT, can be out of the question because the negative denominator causes the multiple to be impractical, i.e. “not meaningful”.
• Forward-Looking Market Pricing: For companies exhibiting high growth and operating in hyper-competitive markets, the priority must be on revenue growth in lieu of profitability. Of course, the company must eventually become profitable to sustain operations, however, the competition in certain industries can force participants to prioritize growth, including acquiring more customers, securing long-term contracts, and running effective sales and marketing campaigns, which are each costly endeavors that can erode a company’s margins.

Forward Multiple Formula

The formula to calculate a forward multiple is as follows.

Where:

• Value Measure: Enterprise Value (TEV) or Equity Value
• Value Driver: Forecasted Financial Metric (e.g. EBIT, EBITDA, Net Income)

The rule for all valuation multiples, whether on a historical or forward basis, is that the numerator and denominator must match in terms of the capital providers represented.

• Enterprise Value: e.g. EBIT, EBITDA, FCFF, NOPAT
• Equity Value: e.g. Net Income, Book Value of Equity (BVE), FCFE

Valuation Multiple: Forward Multiples vs. Historical Multiples

• Historical Multiple: The traditional valuation multiple is based on historical performance, such as LTM EBITDA or LTM EBIT. Historical multiples, or “trailing multiples”, portray how much investors are willing to pay for a dollar of past earnings.
• Forward Multiple: In contrast, a forward multiple reflects the amount that investors are willing to pay for a dollar of future earnings. The benefit to using a forward multiple is that in reality, market valuations price in future expectations more than historical performance, albeit the two are closely intertwined. For instance, if a financially sound, profitable SaaS company trading at a premium were to suddenly announce that its future growth outlook seems unfavorable, and its profit margins should reduce substantially in the coming years, the company’s share price would plummet post-announcement, regardless of its past profitability and historical margins.

What's the Difference Between Forward-Looking and Backward-Looking Multiples?

• Forward Multiples: Considering the forward-looking aspect inherent to corporate valuation – both on an intrinsic basis (e.g. DCF) and comps-derived basis (i.e. trading comps, transaction comps) – a credible case could be made that forward multiples should hold more merit than backward-looking multiples. But projection models are prone to bias and are ultimately estimates at the end of the day, which makes forecasted earnings less reliable with a lack of consistency.
• Historical Multiples: In comparison, a company’s historical performance can easily be confirmed via company reports and formal filings with the SEC. All forecast models regarding a company’s future financial performance require discretionary assumptions, and thus there are large discrepancies in future estimates. Moreover, forward multiples are commonly based on a company’s estimated next twelve months (NTM) performance, but can be extended even further out. The issue, however, is that the further out the forecast period, the less credible the valuation becomes because more uncertainty and external risks emerge. Historical multiples, or “backward-looking multiples”, do not suffer from those types of risks since the value driver is based upon actual financial data, not estimates.

Forward Multiples in Valuation of Software Companies

Forward multiples tend to be most common for software companies (SaaS), where the abundance of capital from venture capital (VC) and growth equity firms – coupled with their disruptive business models – results in prioritizing growth at all costs and capturing as much market share from existing incumbents as plausible.

For example, a SaaS company can be valued at a relatively high forward multiple because the market’s expectation is that the company can achieve its goals in terms of growth and market share, followed by becoming more profitable over time as its business model becomes more efficient.

Furthermore, the market might anticipate its margins to expand as a result of reduced spending as its nearest competitors become less of a concern over time (i.e. competition cools down) as well as the company coming up with more effective strategies at monetizing their user bases (and recurring revenue via long-term customer contracts).

In certain markets, a consolidation phase can occur where competitors can become acquisition targets, as in the case of Postmates and Uber in late 2020.

What are the Determinants of Forward Multiple in SaaS Industry?

In 2020, venture capitalist Tomasz Tunguz performed a linear regression analysis on sixty publicly traded SaaS companies to identify which factors determined the forward multiple of these high-growth software companies.

The key takeaways from the findings were that revenue growth and sales efficiency had the highest correlation, 0.81 and 0.75, respectively.

On the other hand, the other factors like cash flow margin, net income margin, and gross margin were irrelevant, for the most part.

Over the long run, improvements to profit metrics certainly become critical, but growth and sales efficiency dictate forward multiples in the market, even for publicly-listed companies.

^{“How to Predict the Forward Multiple of a Software Company” (Source: Tomasz Tunguz)}

Forward Multiple Calculator – Excel Template

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SaaS Forward PE Multiple Calculation Example

Suppose you’re tasked with calculating the forward multiples of a SaaS company that is currently unprofitable.

The company’s market share price – as of the latest closing date – is $50.00, with a total of 20 million shares in circulation.

• Market Share Price = $50.00
• Diluted Shares Outstanding = 20 million

By multiplying the share price and diluted share count, the implied equity value of our software company is $1 billion.

• Equity Value = $50.00 × 20 million = $1 billion

In fiscal year 2022, the company incurred a net loss of $100 million, but the consensus among equity analysts is that management’s plans to increase profitability in the coming years are promising and likely to materialize.

• Net Income, 2022A (t=0) = ($100 million)

In the next fiscal year, 2023, the expected earnings is $10 million – thus, the company will barely break even – but its net earnings will expand significantly and reach $100 million in 2024.

• Net Income, 2023E (t+1) = $10 million
• Net Income, 2024E (t+2) = $100 million

The forward PE ratio can be calculated by dividing the company’s equity value (or “market cap”) by the net income in each period.

• Forward PE Ratio, 2022A: The actual reported earnings are negative, so the historical PE ratio is negative and thus not applicable (“NA”).
• Forward PE Ratio, 2023E: Given the marginally positive net income, the forward PE ratio is 100.0x and not meaningful (“NM”).
• Forward PE Ratio, 2024E: The estimated net income is $100 million, which returns a forward PE ratio of 10.0x and reflects the use-case of a forward multiple, since only this ratio can be practically used for purposes of relative valuation.