The Use of Multiples in Business Valuation
Selling price divided by EBITDA (earnings before interest, taxes, depreciation, and amortization) is a commonly used valuation multiple. EBITDA does not take into account the owner “add-backs” that include additional owner benefits that ultimately affect the Sellers Discretionary Earnings (SDE). In the small to mid-sized business valuations, SDE is the primary metric when trying to figure out what a business truly cash-flows and then is multiplied by a number according to industry standards.
When a business owner asks me “what is my business worth?”, I respond that we will do an in-depth analysis of not only their company financials, but also need to understand other important contributing factors. We will focus on these other factors in future articles in order to keep the focus on multiples right now.
For a quick example, let’s say the SDE of a seller’s business is $500,000. If we apply a 4 multiple, then the value will be $2M. From the perspective of a potential buyer, assuming the business continues to profit at the same level, they will get $500,000 per year on an investment of $2M, or a 25% ROI. They will get their entire return on their investment within 4 years and become “whole”. These #’s are all assuming that there will not be any additional costs as well (i.e. equipment upgrades, additional staff, debt payments, etc.). This is typically not the case and thus the term to recoup the initial investment is extended.
Another way to look at the multiplier method is with the P/E Ratio. The Price to Earnings Ratio is simply the selling price of the company divided by the earnings or profit that the business generates. This is a common way to look at stock values for investors. When you compare the above 25% ROI versus a typical mutual fund of 8-10%, buying a business appeals to many people. Obviously, there is a lot of involvement and time investment owing a business, but there are additional benefits too. Some of these additional benefits are realized when we are discussing the add-backs previously mentioned. Another benefit is if the buyer is successful and continues to grow the company, they can potentially sell the business for a higher value and/or multiple in the future.
So, what multiple is relevant to the business you own or are looking to purchase? The answer is “it depends”. It depends on not only the black and white #’s, but a whole slew of other contributing factors that are equally important. As I mentioned earlier, we will dig into those items in the next article. We can tell you that in RBA’s experience, we see average range from 1-4x’s SDE. Small businesses with a SDE of under $100,000 typically sell in the range of 1.3 to 2.5. A business that is above $100,000 up to $500,000 can expect a range of 2 to 3 and 3 to 4 up to $1M in SDE. Again, there are many other contributing factors that impact this.
Ultimately the selling price and corresponding multiple will be determined by the market. The process of business valuation is unfortunately more of an art than it is a science. There is nothing wrong with testing the market and trying to get the best deal possible, but please understand that good businesses come with a premium, and good buyers need to be financially able and willing to pay for that. Meeting somewhere in the middle is where the math (and multiple) will end up.