Valuation Multiples Intro

What is my company worth? Every seller’s view = more. Every buyer’s view = what can I get it for? Valuation is both art and science. If you’re a business owner, this is a good time to be objective about what you’ll read next. If you’re a buyer, and have experience looking at businesses today, you probably have a current market valuation multiples. Note: that doesn’t mean a buyer won’t “pay up” or “bargain hunt”, but those are decisions to be made and not necessarily representative of “market”.

Valuation can be affected by a number of things – it is important that you understand the general rules of the road so your expectations are grounded in reality. Below is a framework for how to think about valuation multiples and valuation in general!

It all Starts with the All Mighty EBITDA

Ahhh…the great EBITDA. A word my wife and friends have heard me say so much they think I’m having a secret relationship with it (perhaps I am). EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization – basically a measure of how much “earnings power” a business has if you ignore how it’s currently financed or taxed, or the costs of “non cash” expenses like depreciation and amortization.

There are many potential issues with using EBITDA but it’s the general convention followed by folks in Private Equity and Investment Banking so let’s go with it for the time being (I’ll save “the trouble with EBITDA” for another post!).

EBITDA comes in all forms and flavors with varying degrees of intellectual and financial honesty but for now, let’s just assume that plain Jane EBITDA is the core of what we’re using for our valuation. We’ll ignore “pro-forma” adjustments, “1x add-backs” and “merger synergies” – these can be legitimate adjustments but they can also be a way for eager sellers to pump up the earnings they are trying to “sell” to a buyer.

Finally, one has to consider external factors – primarily those related to debt markets because buyers most often (nearly always) finance purchases with debt and thus the “credit markets” play an important role in determining valuation levels. For example, with recent events stemming from COVID 19, lenders have frozen up and thus transaction volumes have come to a grinding halt. Just two months ago under quite exuberant credit markets, it was possible to borrow “5-6x” or 5-6 times EBITDA. Lenders would typically expect an equity contribution from the buyer of 30% or so…thus, 6x debt, 2x equity meant a generally “floor” of 8x for most businesses that also generated cash flow. In the same scenario, imagine that lenders would only extend 3x leverage, and require 2x equity for a 5x valuation. You get some idea for how credit markets affect valuations now. Better, more accommodating credit markets with lower interest rates = Higher valuations, in general.

EBITDA is important, but Cash is still King!

At the end of the day, interest on your debt cannot be paid in EBITDA, it must be paid in CASH! This means that the “steady state” or “maintenance” Capital Expenditures (CapEx) cannot be so high that you have low “EBITDA to Free Cash Flow” conversion. Bankers love to see a conversion factor of >80%, and get ready for some great valuation numbers if that number exceeds 90%. Note: some sellers will slow down way too far on CapEx in the year or two prior to selling a business so they can push future expenditures on to a buyer…beware of this. If identified, it should be treated as a “debt like item” for purposes of your final bid (market conditions and competitive dynamics allowing of course)!

Look at both EBITDA and Cash Flow Multiples

I said it was going to be all about EBITDA but really, it’s all about Cash Flow Multiples. Since you pay your interest in cash, or will at some point. Another part of Cash Flow is working capital. If the business has a relatively low working capital % sales (say 10-12% or less?), there will not be a discount applied to it’s multiple but if working capital % sales exceeds EBITDA % sales, you should expect a buyer to express concern that the growth of the business consumes more cash than it generates (thus a requirement that they fund that growth, which means lower purchase price in nearly all cases).

The right equation is really, EBITDA – CapEx, with an adjustment for how working capital intensive a business is to operate.

Growth, Profit margins and Valuation Multiples

This is simple. Higher growth rate = Higher Valuation Multiple. Higher Profit Margins (assuming normal CapEx) = Higher Valuation Multiples. In each case the buyer assumes higher revenue and cash flow in the future and thus, is willing to pay you more for that future cash flow today. As your growth rate increase, so does your valuation multiple as long as that revenue growth is seen as sustainable. One Time events like hurricanes for construction companies (i.e. Katrina, Sandy) or other similar events should not be part of the go-forward calculus of your company’s earnings power. Outside of these types of events however, there is a positive correlation between growth rates, profit margins and valuation multiples.

Size Does Matter in Valuation Multiples

As your business grows in size, your valuation will generally rise. The reasons here are simple: financing options to purchase your business continue to become more “buyer friendly” and allow for more debt to be used, your business has more “heft” and likely improved systems, management, financial controls etc. Another reason is that as the business scales, your industry position becomes more relevant and the customer and supplier ecosystems around your business become more stable. Overall, the risk profile of your business declines and the financing options for purchasing your business improve as you gain scale. Now, to put that in perspective: think about $5m increments of EBITDA as thresholds that will matter from a scale perspective. Going from 5 to 6 or 7 to 8 million will not result in any material change in multiple paid for a business.

Economic cycles affect what buyers pay

This part can be completely maddening. When business cycles have “cycled down” and are recessionary, a business generating cash flow will do even better in normal economic times and thus it could be argued that a higher valuation multiple should be paid for each dollar of EBITDA. That isn’t how it goes however, generally, because lenders are not usually willing to be aggressive at those points int he cycle and thus sellers have a hard time getting more value when it is up to private equity buyers, individuals or corporations to pay more cash out of pocket vs. borrow. The same is true at the top of business cycles – one could argue that EBITDA is stretched and conditions are near perfect, thus multiples should contract a bit but they don’t – in fact these are typically peak valuation periods. Buyers pay the most when debt markets are strong, even though there is a solid case to be made that they should take the contrarian view.

Concentration of Cash Flows affects Valuation

I’ll be quick here. If you have a customer that accounts for over half of your business, expect to be valued at a lower multiple than if you don’t have any customers that are over 10% of revenue. In general, buyers are looking for stability and predictability of cash flows and if you have high customer concentration, they will look for ways to reduce their risk by spending less on your company. There are often great reasons for concentration (for example, in retail with big box or in automotive given on a few concentrated players in the space), but nevertheless, expect some “haircut” to market valuation multiples when you have significant customer concentration.

A Summary of Things to Remember:

Start off with the general notion that cash flow generation is critical. Then, look at your growth rate which will take the “base multiple” up or down, adjust for the amount of working capital and CapEx required by your business, and evaluate the customer risk in your industry or business relative to others. These are the levers most buyers will consider when thinking about what to pay for a business. Again, this list is by no means exhaustive but reach out if you have specific questions – remember, valuation is both art and science.