With all its terminology, stepping into the world of investing can be daunting. Nonetheless, an important concept to understand is the equity multiple.
But what is an equity multiple and how can you use it to evaluate the strength of an opportunity?
Also, when and why would you use it over other key performance metrics? Keep reading to learn these answers below.
What Is an Equity Multiple?
For those still scratching their heads about what equity multiple is, let’s try to put it simply.
It a term that describes how much of a profit—or a loss—you expect to make on your money. Meaning, if you put $1 into a deal, how much can you expect to get back? If you get back $2 for every $1 you that invest, that would be an equity multiple of 2.
More specifically, an equity multiple is the total cash distributions received from an investment divided by the total equity invested into that investment.
Thus, an equity multiples measure the total cash return on an asset over the investment’s lifespan.
The equation is:
- Equity Multiple = Total Cash Distributions / Total Equity Invested
While this might seem similar to return on investment (ROI), equity multiple is a ratio rather than a percentage.
Most often, an equity multiple is used to evaluate real estate investment opportunities. However, it can be used to evaluate any type of investment in which you are investing money with the intent to make a profit. For example, you could use it to evaluate a business that you are considering buying.
Many times, it is used to make projections before you invest. Obviously, you would use using estimated figures in this case. Other times, it is used to calculate the performance of an investment once it is complete. In this case, you would be using concrete figures.
What Does an Equity Multiple Mean?
When you calculate an equity multiple, you want it to be above 1.0. This is because the ratio indicates the return you have earned on each dollar that you spent. Thus, an equity multiple of:
- Less than 1.0 means you’re losing money
- Equal to 1.0 means you’re breaking even
- Greater than 1.0 means you’re making money
For example, if your ratio is 2.0, you will make $2 on every $1 you invested into the property over its lifespan. That is a doubling of your initial funds.
It’s important to note that a equity multiple of 2.0 means that you got your initial $1 investment back, plus a profit of $1.
How to Calculate Equity Multiple
Next, let’s discuss how to calculate an equity multiple on your investment properties.
The first information you’ll need to gather to calculate your equity multiple is the total money invested into the property. Next you will need to estimate the value at which you will sell the property and your expected cash flow along the way.
A Simple Example
First, let’s start with a simple example of how to calculate an equity multiple. Let’s say that you bought a single family home (SFH) for $200K in 2022 and sold it for $300K in 2027. In this case, your math would be:
Total Cash Distributions of ($300K) / Total Equity Invested ($200K) = An Equity Multiple of 1.5
The reason this example is so simple is that we don’t have to account for any cash flow along the way. We simply have our purchase price and we have our sales price, which produces an equity multiple of 1.5.
A More Advanced Example
Next, let’s do a slightly more complex example. For this example, let’s assume that you invested $100K into a real estate syndication.
Over the course of the five years that you were invested in this opportunity, you were paid out $10K per year in cash flow ($50K total).
Let’s also assume that you received $150K when the assets you invested in were sold. That $150K would contain a return of your initial capital invested of $100K, plus a profit of $50K.
Thus, your total cash distributions would be $200K, produced from a combination of $50K in cash flow plus $150K from the sale of the real estate assets.
In this case, your math would look like this:
Total Cash Distributions of $200K / Total Equity Invested of $100K = An Equity Multiple of 2.0
A More Complex Example
Finally, let’s do a slightly more complex example. Let’s say that as an investor, you purchased an apartment building for a total of $5 million around six years ago. The present valuation of the property is now $10 million. If that was the only way you made money from the deal, then your math would look like this:
$5 million (Total Equity Invested) / $10 million (Total Cash Distribution) = 2 (Equity Multiple)
But if you had rented out the property and made $200,000 annually for six years, then you’d also have to include $1.2 million in total cash distribution. In this case, your equation would look like this:
Total Cash Distributions of $11.2 million / Total Equity Invested of $5 million = An Equity Multiple of 2.24
It’s important to note that equity multiples formulas can also include expenses and additional investments you might have to make over time to maintain your investment.
In this case, the expenses would reduce your total cash distributions, while additional investments would increase your total equity invested. Either way, these items can easily be accounted for in your calculations.
Problems with the Equity Multiple
While an equity multiple is an easy metric to understand, it is a limited metric, because it does not account for time. Obviously, it’d be way better to get an equity multiple of 2.0 over three years than to get that equity multiple of 2.0 over 10 years, because of the time value of money.
As we all know, a dollar today is worth more than a dollar a decade from now.
To get a better idea of the growth of your investments over specific spans of time, you will want to use a different metric instead. Good metrics for this purpose include Annual Recurring Revenue (ARR) or Internal Rate of Return (IRR).
An ARR is a formula that calculates the annual percentage rate of return expected from an investment compared to the initial cost, while an IRR lets you estimate the future profitability of potential investments.
Of those two metrics, the IRR does a better job of accounting for the time value of money.
We discuss these formulas in more detail in an article about the differences between the two.
Understanding the Equity Multiple
Working out your equity multiple can be confusing and getting it correct matters.
Put simply, an equity multiple will tell you how much money you can expect to earn from your investment. Having said that, it will not tell you how long it will take you to receive those earnings, which is its major drawback.
What questions do you have about the equity multiple? Ask them in comments below.
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