Understanding Valuation Multiples

There are many reasons to buy a firm, and some of those have very little to do with the financial side, but a valuation uses various formulas to assign an actual dollar value to the firm. That’s where it starts, and if the purchase is a money play, the final valuation won’t stray too far from that resulting number. If there are other reasons for the transaction, it might, or a buyer might even beat you up in the negotiations, using that valuation, even if the purpose of the acquisition isn’t about money. Why not use the ammunition at hand, right?

What is EBITDA

One of the questions that we get a lot is this: “Hey, what’s the going multiple [of EBTIDA] these days?” The real question is more complete if you include what I did in brackets, though, and so that brings us to EBITDA and what it is.

EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” EBITDA is always a higher number than net profit because you calculate net profit “after” you subtract those four things from your earnings, which is exactly the same thing as adding those four things back to your net profit.

What are Multiples

Now back to multiples. Multiples were first developed and applied in the 1800s. The idea was to come up with some standardized way to compare relative assets. The assets being compared were companies, and the standardized method of comparison was the extent to which each company generated profit. That’s basically the core of valuation theory: how to compare the relative degree of profit. This was such a core concept that multiples became the primary way of setting the value of firms in the 1900s, through the court system and economic journals. Why those four things (ITDA) were chosen as factors in the equation is a deeper subject which I’ll be discussing in an upcoming book titled Selling a Professional Service Firm: A Primer, released in the fall.

Let’s pause for a second, because this should strike you right in the heart. When you are selling a firm, the buyer wants to know, primarily, how successful your firm has been in creating profit. The buyer doesn’t want to purchase your firm because it’s provided you a job, reflected in your salary, but whether or not it generated a profit after all expenses were paid, including your compensation. The buyer will care about how much you paid yourself, because they want to make sure that you weren’t subsidizing that profit simply by paying yourself less than expected, but otherwise the buyer just wants to know how profitable the firm was.

Over time, financial analysts have developed more sophisticated valuation methods, moving away from multiples to consider things like DCF (“discounted cash flow”), but those are more appropriate for firms in industries that require heavy indebtedness, and thus a tighter focus on returns after servicing that debt. But those of you reading this are primarily running smaller professional service firms where debt is not a traditional consideration for ongoing operations. There may be some debt, but servicing that debt is usually a very small part of the firm’s financial performance. This is important, because any valuation methodology more appropriate for a manufacturing environment with huge capital requirements (machinery, equipment, facilities, inventory, etc.) will not usually be as relevant as a simpler and fairer valuation based primarily on a multiple.

It’s better to not think of multiples as the result of some mathematical formula that, when applied to your firm, tells us how to value the firm you are selling. No, multiples are simply comparative and historical. They are based on what other firms like yours have sold for. They fall within a narrow range, and the valuation expert needs to assess a specific multiple based on factors unique to your firm, but the range itself is only unique to firms like yours that have sold in the recent past.

That narrow range of the multiples is based on the NAICS code within which your firm is categorized. Most of you readers, here, would fall under this code: 54XXXX, where the four numbers after that larger 54 category delineate whether you are in architecture, engineering, legal, consulting, marketing, etc. For marketing firms, for instance, that multiple range has historically been 2.5x on the low end to 12.5x on the high end, with the vast majority falling somewhere in the 4.0x-6.0x range. There have to be really good reasons to go below that range, and exceptionally great reasons to go above it.

How They Are Applied

Keep in mind, though, that these multiples are applied very specifically. For instance, they are applied to EBITDA and not net profit. Multiple years are included and then averaged together, and not always in a straight average but a weighted average. And principal compensation needs to be normalized, any unusual expenses need to be subtracted (these are called “add backs”), and so on.

Where does the information come from when assigning a multiple? There are many sources, but these three capture most of the options:

• Experience in doing valuations and defending them
• Networking with other valuation experts and comparing notes
• Public databases of completed transactions (DealStats, e.g.)

The clarity of the method based primarily on multiples is wonderful, but people focus on it too simplistically. Like I noted above, we’ll be asked frequently what the going multiples are these days, for instance, and we’ll answer the question, but it doesn’t really mean anything. It’s like asking someone how much their friend weighs, without knowing if they are male or female, how tall they are, how old they are, and where the weight is distributed. It may be a great place to start, but it doesn’t mean all that much in isolation. Multiples are relative, and they should not be viewed in isolation.

But it is where a buyer will start, and that shines a light on one of the most fundamental purposes of a business: how profitable is it. That may not matter to you, but it’ll matter to the buyer…or they may pretend that it matters to beat you down on price.

Let us know if we can help with a valuation. Our model is understandable, and it’s something that you can take with you and update over time. We will assign a multiple, but we’ll also make more than a dozen other adjustments and explain why and how they were applied.