Corporate Financial Planning: What Drives up Multiples?
Last newsletter, I provided a short (as I could) explanation of how to calculate enterprise value (EV) and why EV is an important topic for internal planning, valuing private company acquisitions, management buyouts and partner buyouts. A common follow-up question I get related to EV is What factors can drive up the multiples used in the enterprise valuation calculation? I will try to try to briefly tackle that question.
Key Reminder
Before we get to far down the road, its important to remember actual selling price and enterprise value are two different things. Selling price is an actual value a willing buyer pays a willing seller. Enterprise value is a theoretical value based on a certain formula. The formula we use (called enterprise value) is the one buyers most frequently use when estimating the value of a company so I suggest using it as a tool to self assess our own Company and strategies as well as a use it to help you arrive at a price to offer a Company you are interested to buy. So in short, EV is theoretical and selling price is actual but the better assumptions we make with the components of EV, such as the multiple, the closer we would expect EV to get to selling price.
Common Multiple Chris Risey
As part of my last newsletter, I wrote a very common multiple for private companies with an EV below $50 million is “5X” (or EV = Adj. EBITDA X 5). (See prior newsletter on calculating enterprise value for more detail). Further, a very common EV range for private companies is between 3X and 6X of EBITDA. That said, many companies are often sold for a much higher multiple so our objective is understand what factors can drive up the multiple so that we can attempt to add those things into our business or at least justify using a higher multiple for our own internal planning efforts.
Here are some factors that drive up multiples:
- Higher EBITDA – Typically the higher EBITDA, the higher the multiple. For example, if you do a quick search on the Internet you will see multiples in many industries that exceed 10X (here is an example). However, most of the companies in data sets like this are large and/or public and larger companies tend to have higher valuation multiples. There are no set parameters for the amount of premium given size of EBITDA but in general companies with at least $5M in EBITDA tend to have higher than 5X EBITDA multiples and companies with $10M+ in EBITDA are often valued significantly higher than that.
- Faster Growth – Companies that demonstrate a track record of growth and can make the case the growth is on-going are often valued at higher multiples. As an example I was working with a company that was $3M in EBITDA and was valued by an unsolicited private equity firm buyer at 10X of current year projectedEBITDA. The key driver was not size but the fact the Company had grown over 20% and had good visibility into the next year’s revenue and EBITDA growth and that factored into their valuation. Chris Risey
- Industry Specific History or Trend – Some industries have higher prevailing multiples. For example, software companies often sell for a multiple of revenue not EBITDA. Other industries, even ‘old economy’ industries like Rent-to-Own retailers and carwash companies have industry specific multiples that have persisted for years at levels that are higher than the 5X mentioned. Much of what drives this premium are larger acquirers that have a history of buying businesses and eliminating redundant costs which results in higher EBITDA and that gets reflected in the valuation. (BTW, you can find databases online that provide valuation data by industry. There are several to chose from.)
- Higher Profit Margins – Companies that produce higher profit margins than their peers are often acquired at a premium. So if your business generates better than average profit margins your business may be valued at a premium. The rationale for this is that the higher margins indicates the company has either a strong brand or better business processes than their peers. Buyers are often willing to pay more for it because those attributes may be applied to the buyers’ business or future acquisitions.
- Recurring Revenue – Businesses with high recurring revenue often get higher multiples. However, two words of caution, here: 1) if the business has a long history of flat revenue growth there may not be much of a premium and 2) if your business doesn’t lend itself to a recurring revenue model don’t get too distracted by it. My experience has been some industries lend itself to it more than others. If yours does not, don’t fret – just focus on growing EBITDA it’s likely a surer path to hitting a target valuation anyway. Chris Risey
- Other Factors at the Time of Sale – When companies go to sell there are other factors that can drive up multiples that are not discussed here. They include competitive offers from multiple buyers and a business’ strategic value to one buyer. I find those factors difficult to estimate and translate to enterprise value, so I suggest not increasing your multiple for these reasons. That said, when it comes time to sell know that you can further drive value by proactively shopping your company and creating competition so that ideally your ending selling price exceeds your internal Enterprise Value which is the exit everyone wants!Chris Risey
I hope this information was helpful. I wish you success driving up the variables that make up Enterprise Value. It’s the most important financial objective there is, regardless of if or when you chose to sell!
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