7. Step #1 – Pick metric

FAQ: “Why not use entry multiples that are FURTHER into the future than the next twelve months (NTM)?”

The main reason is that it’s really hard to predict what will happen in the distant future. Even experts find it challenging to forecast beyond a year, let alone five years or more. There’s a lot of uncertainty and guesswork involved when we try to look too far ahead.

However, while we use NTM multiples as our main reference point for valuation, we can still consider future projections as part of our analysis.

For example, if you have a strong belief in a company’s projections for the next two years, you can use that information to assess whether the current valuation looks good or not.

But it’s also important to remember that we usually don’t rely solely on far-out projections for valuation. We take into account other factors and use them in combination with the NTM multiples to make a more well-rounded assessment.

In a nutshell, while future projections can give us some insights, we primarily focus on the next twelve months because it’s hard to predict what will happen in the distant future and we want to avoid relying too heavily on uncertain forecasts.

FAQ: Why use a “forward” multiple in valuation?  Are you “double counting”?

By using the “forward” metric, you might wonder if we’re double-counting or inflating the valuation.  The reasoning is that the “forward” metric is a bigger number than LTM, which boosts the valuation, plus the multiple applied will be high if the company has an attractive growth rate (another boost to valuation).

As a growth equity investor, your primary focus should be on forward multiples. The purpose of using projections is to assess the future potential and performance of the business.  Investors, especially those focused on growth, often consider both forward and backward multiples to ensure reasonability.

You set the valuation by setting forward multiple (e.g. Next Twelve Months multiple) as fixed, then the backward multiple (e.g. Last Twelve Months multiple) is implied based on that valuation.