Business owners often hear statements such as, “Businesses in our industry sell for three times profit.” It sounds straightforward, but valuation multiples require considerably more context than that. A multiple can be an important part of an earnings-based business valuation, but using the wrong earnings figure or the wrong multiple can produce a valuation that bears little relationship to the actual business. This is why simply comparing one business with another based on a headline multiple can be misleading.
What is a valuation multiple?
At its simplest, a valuation multiple is applied to a financial measure of the business to estimate value. For example, an earnings-based valuation may involve determining maintainable earnings and then applying an appropriate multiple to that figure. But both parts of that equation matter. Before discussing the multiple, there needs to be clarity about exactly what is being multiplied, how that figure was calculated and whether it fairly represents the underlying performance of the business.
Not all earnings measures are the same
Depending on the business and valuation methodology, discussions may refer to measures such as EBITDA, EBIT or other adjusted earnings figures. These measures are not interchangeable, and a multiple of one earnings measure cannot simply be compared with a multiple based on another. This is one reason informal conversations about valuation multiples can be misleading. Two people may both say that businesses sell at a certain multiple while actually referring to completely different calculations.
Why doesn’t every business in an industry receive the same multiple?
Because a multiple also reflects risk and quality. Consider two businesses operating in the same industry with identical maintainable earnings. One has a diversified customer base, an established management team, recurring revenue and documented systems. The other relies heavily on one client and requires the owner to manage virtually every important aspect of the business. Applying exactly the same multiple to both may fail to reflect the difference in risk. Industry benchmarks can be useful, but they are a starting point rather than the entire valuation.
Market evidence can help inform the assessment
Where reliable information is available, transactions involving comparable businesses may provide useful valuation evidence. However, truly comparable transactions can be difficult to find because businesses vary in size, profitability, location, customer mix, structure, growth and risk. The headline sale price also does not always reveal the underlying terms of the transaction, such as earn-outs, vendor finance or other conditions. Comparable evidence therefore needs to be interpreted carefully rather than copied without context.
The highest multiple is not automatically the correct multiple. It can be tempting to search for evidence supporting the largest possible valuation, but a valuation needs to be defensible. A higher multiple applied without sufficient justification may create unrealistic expectations, particularly if the owner later takes the business to market. Multiples are useful tools, but they only make sense when the reasoning behind them makes sense too.
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Regards,
Tony Arena