If you’ve read many of my posts, you know that I’m not much of a fan of using rules of thumb, simplistic multipliers, or a market comparable approach to value businesses. One of the first things that Codiligent business brokers does when working with a new business sale client is to go through a comprehensive analysis and valuation where multiple approaches to value are considered and a variety of assumptions are used. However, if someone instead is going to estimate value using such a rule of thumb or multiplier, they should at least use an appropriate financial metric as the basis for the value estimate.
Last week, I was contacted by a prospective business buyer who was suggesting that a business I was representing was over-priced. His reason for thinking so? Another broker who has represented other businesses in that particular industry provided him with data on a variety of sold comparable businesses and told him that businesses in that industry sell for 10-12x monthly revenue. The sold comparable data certainly seemed to support this contention.
Here’s the problem with this, though: revenue has very little to do with what something should be worth. Rather, cash flow is what creates value. Let me explain why:
A comparable business that sold for $4,166,667 may have had $5 million in revenue. If the average business in that industry has EBITDA margins that are 11%, then it may have had $550,000 in EBITDA. If, as the buyer who contacted me suggested, an appropriate price was 10x monthly revenue ($5 million / 12 months X 10 months) then as previously mentioned, the value may have been $4,166,667. The $550,000 in EBITDA would represent a 13.2% EBITDA return on investment in the first year.
Yet, what if another business in the industry also had $550,000 in EBITDA, but it was a far more efficiently operated business and as a result its EBITDA margins, at 25%, are far higher than average, then it would have only $2.2 million in annual revenue. If you used this buyer and his advisor’s formula of 10x monthly revenue for value, it would suggest a value of only $1,833,333. The $550,000 in EBITDA would represent a 30% EBITDA return on investment in the first year.
Since the industry average EBITDA return on investment was only 13.2%, why would a buyer expect to achieve a much higher EBITDA return on investment of 30% for a company that is better operated and thus more profitable? Logically, the company with the higher margins should be valued higher, all other things being equal, not lower than the poorer performing comparable businesses.
A better way of comparing businesses is to look at a multiple of EBITDA (after paying an owner/manager a market rate of compensation). In my example above, the average business that had $550,000 in EBITDA, 11% EBITDA margins, annual revenue of $5 million, and a price of $4,166,667 would have sold for 7.58x EBITDA. If you apply that same EBITDA multiplier to the latter business that also had $550,000 in EBITDA, 25% EBITDA margins, and annual revenue of $2.2 million, it would result in an estimate of value closer to $4,169,000. This would mean that the EBITDA return on investment for the single business with higher margins would be consistent with the comparable sold businesses: both would have EBITDA returns on investment of approximately 13.2%.