In addition to teaching a “How to Value a Business” continuing education course each year, I am also asked to speak to various groups of CEOs, entrepreneurs and business owners on the same subject. Regardless of the audience, invariably, someone will ask, “Jim, this valuation stuff is all well and good, but what is a simple multiple of earnings or formula to use to value a business?”
Face it, we all love shortcuts. We learn at an early age the benefits of shortcuts: whether we cut through our neighbor’s yard on our walk to school, clean our room by stuffing our messes into our closets, or even feed our unwanted vegetables to our dog (surreptitiously under the table, of course) so we can get the dessert our mothers’ promised if we clean our plates, who can resist a good shortcut?
Today, I still use the shortcuts my high school mathematics teacher taught us to check our addition and how to quickly multiply by 25. I doubt any of us can get through the day without utilizing at least one shortcut we learned as kids. For business buyers and sellers, multiples are simply shortcuts to the valuation and/or negotiation process.
When applied properly, multiples can be used effectively as sanity or temperature checks/gauges. However, I personally would not want to buy or sell a business based strictly upon a multiple. There are always so many variables to consider when acquiring or selling a business; basing such an important decision on a simple multiple does not make sense. Take a look at the following, admittedly simple, example as a way of illustrating my point.
For example purposes, let us assume Company A and Company B each manufacture virtually identical widgets. Each company is organized as an “S” Corp with a single shareholder looking to sell for retirement and estate planning purposes. Also assume neither company has any interest bearing debt. (Note: the fact that we have to outline so many variables before ever discussing the performance of the companies should be a dead give-away: valuation multiples are not as valuable as we think.) The key operating data for each Company is shown in the table:
| . | Company A | Company B |
| Revenues | $10,000,000 | $10,000,000 |
| Gross Profit | 30% | 30% |
| Operating Profit | $1,000,000 | $1,000,000 |
| EBITDA | $1,500,000 | $1,500,000 |
| A/R | $1,200,000 | $900,000 |
| Inventory | $1,600,000 | $800,000 |
| A/P | $600,000 | $400,000 |
| Net, Plant, Property & Equipment | $1,250,000 | $900,000 |
All things being equal, which business is worth more, Company A or Company B? A multiple of earnings would tell you both companies are exactly equal. However, Company A’s hypothetical net worth is more than 50% greater than Company B’s net worth. Is that important to a buyer or seller?
If the acquirer is using leverage to make the acquisition, theoretically, Company A would be more valuable because if both companies are valued by the same multiple of earnings, the buyer of Company A would have to infuse less of its own capital than if it acquired Company B. Thus, in theory, to a leverage buyer, Company A is more valuable and the buyer could, theoretically, afford to pay more for Company A than Company B (because while the acquirer’s own invested capital will remain constant, if the acquirer can use more leverage for Company A, the acquirer can pay a higher price or earnings multiple).
However, if the acquirer is a pure cash-flow buyer, Company B will be more attractive because of its ability to achieve earnings on the same level as Company A with a much greater return on overall capital. Thus, a cash flow buyer would be able to place a higher value on Company B than Company A.
Imagine one more variable to the above scenario: assume Company B earns the exact same amount of operating profit and EBITDA as Company A, but on revenues 40% lower than Company A. Using a multiple of earnings, these two companies have the same value, but would an acquirer pay the same for each one?
In the real world, no two companies are ever as closely matched as those in the example above. However, I think this much is clear: multiples are not the only metric to use when trying to determine the value of a business.
Of course, we know certain businesses and certain industries have long-established acquisition guidelines (fast food restaurant chains, auto dealerships, banks, etc.) but rarely are these multiples set in concrete. Multiples are generally used as a guide, not a rule. Used incorrectly, they can produce dangerous results for buyers or sellers.
For example, recently we meet with the owners of a local manufacturing business. When we discussed their value expectations, they said, “We heard you sold our competitor’s company to a Private Equity Group for 7 times EBITDA. That’s what we want.” We pointed out the following to these owners: our client was roughly 5 times larger than their company in terms of sales and profits; our client had proprietary products while they did not; we sold our client’s company at the beginning of 2008, not 2010; and, finally, without violating confidentiality, we could attest to the fact their competitor did not get 7 times EBITDA for their company. Despite these data points, the owners were unmoved: “We want 7 times EBITDA or we will not sell our business.”
Another challenge with multiples is they are, in essence, post-mortem accounting. Purchase price multiples are determined only after a transaction has closed, at which point the data is naturally “stale.” Furthermore, in times of rapidly changing fortunes, multiples rarely change as rapidly as the economy.
Consider this: if you are contemplating an acquisition today, in the Winter of 2010, would you want to base your decision on purchase price multiples calculated from data for transactions closed prior to the Fall of 2008 when the economy came crashing down? As a buyer, your answer is a resounding “no.” As a seller, the answer may be, “it depends.”
In my upcoming article to be published here early next month, we will review where purchase price multiples are in today’s market and the impact banks/lenders play in the game. Until then, remember: multiples are nice to discuss, but I would not want to make a multi-million dollar decision based on a multiplier.
posted by Jim Zipursky