For What Its Worth - Summer 2004
Summer 2004 PDF
Summer 2004 Articles
When advising clients on the valuation/pricing of businesses (both buying & selling), one of the most common (and often first-to-be-asked) questions we are asked is: What multiple are you using? Clearly, the selection of a multiple is a crucial determinant of value or price. However, in our experience, the base that the multiple is applied to is just as important, and unfortunately, probably even more misunderstood.
Underlying valuation theory states that the multiple of 5 implies that the buyer is looking for a rate of return on his/her investment of 20% (the inverse of 5 is 20%, or 1 divided by 5 = 20%).
Multiples of discretionary earnings for privately-held businesses are similar to the public company P/E multiples which are quoted in the financial press. However, public company multiples are often much higher than equivalent multiples for private companies (because of size, growth and liquidity issues).
But, what if the seller is applying a multiple of 5 to the most recent year’s earnings (the highest ever achieved in the company’s history) while the purchaser is expecting to pay based on the average of the last five years earnings (because he/she believes the highest, most recent year is not achievable in the near term)? Obviously, there could be a significant price gap between the seller’s expected selling price and the purchaser’s willingness to pay, even when using the same multiple!
Let’s consider valuation theory again. The base of earnings in this type of ‘earnings capitalization’ technique is meant to be the level of discretionary earnings expected to continue into the future, i.e. the buyer is paying for future earnings, not historical earnings. Nevertheless, buyers and hence valuation analysts look at history as a guide to those future earnings because recent history can be a strong predictor of future performance. In addition, in cyclical or widely fluctuating industries using an average of recent historical earnings can sometimes represent a proxy for expected future earnings.
Enterprise Value Multiples
In larger and mid-market businesses, buyers will focus on base measures of profit higher up the income statement, such as EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). This has become a commonly-used measure of operating cash flow, at least in part because it measures the success of a business before considering the impact of financing & capital decisions. Many large entities look at potential acquisitions on the basis of operating cash flow because how the target has financed its assets (i.e. interest-bearing debt) or how it has written off those assets (i.e. depreciation) is irrelevant to a larger entity with its own financing sources and plant capacity.
The collection of operating assets of a business (working capital, real estate, equipment, goodwill & other intangible assets) generate operating cash flow, ie. EBITDA, which is then used to:
- finance debt (the “Interest” charge);
- pay income taxes (the “Taxes” charge);
- fund replacement of fixed assets (the so-called ‘capex’ charge, which “Depreciation/ Amortization” can be a proxy for)
The remaining or “discretionary” cash flow is available for distribution to the owners, or alternatively, reinvestment in the business to generate greater levels of EBITDA in the future. This collection of operating assets that generates EBITDA is either called “Invested Capital” or “Enterprise Value”. This is not the same as equity value. Expressed another way, the addition of interest-bearing debt to equity value results in enterprise value.
In our experience, one of the most common pitfalls of entrepreneurs planning for a sale is applying EBITDA multiples that are being quoted for their industry (and are meant to determine Enterprise Value) to their own expectations for a share sale – the essential difference being that buyers either insist on the debt being paid off prior to the transaction, or a direct reduction from Enterprise Value to arrive at the share price.
In many industries (and particularly for small businesses), multiples of earnings or other bases are sometimes used to derive a value/price for goodwill, i.e. intangibles that generate cash flow over and above the value of tangible assets (the latter being real estate and equipment). For example, some entrepreneurs are willing to pay for goodwill of up to 3 years worth of after-tax earnings, depending on the type/size of the business.
Occasionally, these goodwill multiples are quoted on other bases, such as revenue, earnings before taxes (EBT) or activity levels (such as per nursing home bed or hotel room). Insurance agencies, as another example, are often sold on the basis of a multiple of annual commission revenue for the value of goodwill and the customer list.
The use of revenue as the base for the multiple reflects the interest of consolidators in that industry focused on ‘the top line’ because they tend to bring acquisitions into their own operating and cost structures (hence, the existing cost structure of the target isn’t relevant to some acquirers). A common trap is for an actual purchaser (i.e. someone who is not one of these ‘special purchasers’) to pay on the basis of industry multiples that reflect a level of synergistic earnings that he/she may not be able to realize upon as a standalone buyer.
It is crucial to recognize that these goodwill multiples do not reflect the equity value of the business. In those industries where goodwill multiples are common, positive/negative adjustments to the goodwill price must then be made to arrive at equity value. The addition of non-goodwill assets and the subtraction of liabilities on the balance sheet (so-called “net assets”) must be considered in the equity value.
- When someone quotes a valuation or pricing multiple to you, make sure you (& they!) understand whether it is a share, goodwill or Enterprise Value multiple – the ‘right’ multiple applied to the ‘wrong’ base can still result in a significant price gap between buyer and seller! In our experience, many transactions that initially make business sense can’t be consummated because of this price expectation gap.
- Generally speaking, a multiple that is quoted on the basis of after-tax earnings is typically a share (or net assets) value/price, while a multiple of EBITDA is almost always an Enterprise Value (from which debt must be deducted to arrive at a share value/price). A multiple of revenue or an industry-activity ratio is either Enterprise Value or goodwill/intangibles, but almost never a direct share value/price.
FWIW is intended to inform readers of developments in the field of valuation. The articles written may, or may not, reflect the opinion of the authors. Please note, any advice contained in this publication was not intended, or written, to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This publication is distributed with the understanding that the publisher and distributor are not providing legal, accounting or other professional advice and assume no liability whatsoever in conjunction with the information contained within this publication.