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Business valuation 101: Demystifying the multiple (Part 1)

September 08, 2017

Business valuation 101: Demystifying the multiple (Part 1)

Synopsis
4 Minute Read

When it comes to succession planning for business owners, the two most common questions asked are: “What is my business worth?” and “What is the multiple for my business?”

Part One of a two-part series on business valuation fundamentals – worth and multiple.

When it comes to succession planning for business owners, the two most common questions asked are: “What is my business worth?” and “What is the multiple for my business?”

Seemingly simple questions; however, in order to get at the answers, one must first define what is meant by “worth” and, second, what is the “multiple” being applied to. Some of the most common mistakes made by business owners when quantifying what they think their business is worth involves the application (or misapplication) of the multiple. Another common mistake is underestimating the role of the qualitative factors that go into the selection of an appropriate multiple – the same factors that make a business more or less valuable and sellable.

What is it Worth?

When business owners ask what their business is worth, they are typically referring to the price they can expect if they sold the business. Broadly speaking, price is measured by a specific buyer’s assessment of the company’s risk and return, which is guided by the concept of “fair market value.”

Fair market value is defined as “the highest price, expressed in terms of money or money’s worth, available in an open and unrestricted market between informed and prudent parties acting at arm’s length and under no compulsion to transact.”

Multiple of What?

A business is commonly valued by referencing “a multiple” which is a valuation metric that is determined after considering the market’s perceptions of the risk and expected future growth (return) inherent in the target business and its industry.

The multiple can refer to various metrics (such as a multiple of revenue, (EBITDA), after-tax earnings, or cash flows). The appropriate metric is typically a key performance indicator for the target company. Most business owners think in terms of a ‘multiple of earnings,’ for example, “I should be able to sell my business for five times earnings.”

Three Common Mistakes

Three common mistakes when business owners try to quantify the value of their business include: Not using the industry rules of thumb correctly; Applying the right multiple to the wrong metric; and Overlooking the balance sheet.

It’s important to use rules of thumb with caution. One size does not fit all. There are rules of thumb that have come to be used in some industries based on industry-specific metrics. For example: Internet or social media-based companies may use a multiple of clicks, conversions, or users/unique visitors; Hotels or homecare facilities often use a multiple of the number of rooms or beds; or Insurance agencies will refer to a multiple of annual commission revenue.

Rules of thumb for other industries may be based on revenue or profitability metrics. The following is a summary of some of the more commonly used valuation metrics: A Price to Earnings (P/E) multiple, which is calculated as a company’s share price divided by the company’s earnings (net income) – this is often quoted for public companies; Enterprise value (EV) to cash flow multiple, which is calculated as the company’s enterprise value (that is, its equity plus debt) divided by its free cash flow (cash flows is EBITDA – defined as ‘earnings before interest, taxes, depreciation and amortization’ - minus income tax, capital expenditures and working capital requirements); and EV as a multiple of ‘earnings before interest, taxes, depreciation and amortization’ (EBITDA), which is calculated as the company’s enterprise value divided by its EBITDA.

From there, it’s critical to select the right metric to determine the multiple. The most common multiple referenced in private company valuations and transactions is EV to EBITDA. The other way to think about this multiple is: how many times you multiply EBITDA to equal the company’s EV or how many years of EBITDA determine the company’s EV. The higher the multiple, the higher the resulting value of the company.

These valuation metrics are often referred to when pricing businesses, but beware of using rules of thumb incorrectly – e.g. applying the same multiple to all businesses in the industry. No two businesses are exactly alike. A multitude of factors must be considered when selecting the appropriate multiple, including: differing customer base; capital expenditure requirements; debt/equity structures; and growth expectations. More on this later.

Part Two of this two-part series will further demystify what ‘multiple’ entails in business valuations.

Contact Craig Maloney, Managing Director, Corporate Finance, Valuations and Litigations Support, at 902.835.7333 or [email protected].

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