What Multiple is Used When Valuing a Company?
When pricing a business, many owners ask: What multiple is used when valuing a company? Multiples are financial ratios that provide quick value estimates based on metrics like earnings or revenue. They are most often used by buyers, investors, and valuation experts. But not all businesses use the same valuation multiple. The industry, business size, cash flow, growth potential, and risk all influence which multiples are best. In this article, we discuss how valuation professionals choose and apply valuation multiples.
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What is a Valuation Multiple?
To answer the question, “What is a valuation multiple?”, think of it as a shortcut to estimating a company’s value. It is determined by assessing recent sales of similar companies on the market. Business appraisers then multiply it by a financial metric like earnings, revenue, or cash flow to get a fair market value estimate. Buyers and investors prefer multiples because they simplify comparisons between businesses and provide a quick valuation.
There are several types of valuation multiples for small businesses. The most common include EBITDA, SDE, and revenue multiples. Each reflects a different aspect of the business’s performance. To determine what multiple is used when valuing a company, business appraisers must consider its size, financial performance, and industry.
The EBITDA Multiple
One of the most common ways to measure value based on profitability is by applying the EBITDA multiple. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This metric measures how much the business earns from its core operations, rather than its net income. It removes the impact of financing choices, tax strategies, and non-cash expenses. With this insight, buyers can more easily assess a company’s performance and compare it to similar businesses.
The SDE Multiple
Buyers often rely on the SDE multiple for small to mid-sized businesses. SDE estimates a company’s value in relation to its seller’s discretionary earnings. This value reflects net income plus the owner’s compensation and personal expenses. Business appraisers use this metric to reflect the true income an owner can expect from the business. After calculating SDE, valuation analysts apply a valuation multiple to estimate the fair market value of the company.
The Revenue Multiple
Another common valuation multiple is the revenue multiple. Instead of focusing on profit, this method values a business based on its total annual revenue. It is often used for fast-growing businesses or newer companies with little or no profit.
While the revenue multiple has its benefits, it is rarely the preferred approach. The revenue multiple only accounts for revenue, not expenses. As such, it proves a less reliable valuation technique. A professional business appraiser determines what multiple is used when valuing a company.
When to Use a Valuation Multiple?
A valuation multiple is most useful when you need a quick, market-based estimate of a business’s worth. Instead of guessing, multiples help buyers, sellers, and lenders compare the company to others that have recently sold. They are usually used early in the valuation process to set expectations and guide decisions. Here are common examples of when to use a valuation multiple:
- Selling a business
- Buying a business
- During partnership changes or buyouts
- Applying for financing
- During divorce or legal disputes
- For tax or estate planning
- Tracking business growth over time
Understanding what a valuation multiple is and when to apply it promotes informed decision-making. It also helps business owners stay realistic about their company’s market value. With this clarity, you can set stronger goals and prepare for future opportunities.
Peak Business Valuation has valued thousands of businesses across the United States. Our valuation experts select the right valuation multiples when valuing your business. To learn more about your business valuation, reach out to Peak! Schedule a free consultation below.
What Influences Valuation Multiples?
Once you can answer “what is a valuation multiple,” the next step is to understand what drives their value. Both internal performance and external market conditions influence valuation multiples. Consistent revenue, healthy profit margins, and steady cash flow are some of the primary factors that influence a valuation multiple. Moreover, strong growth potential often justifies higher multiples, as buyers pay more for companies with room to expand.
Industry trends also have a significant impact on valuation multiples. If the sector is growing or in high demand, multiples may rise. Low risk is another key factor. For example, a business with diverse customers, clear financials, and efficient operations is more stable and boosts buyer confidence. This supports a higher valuation multiple.
The Danger of Using “Rule of Thumb” Multiples Alone
Valuation multiples are ‘rules of thumb’ methods for valuing a business. In other words, they provide simple, one-size-fits-all estimates. Because they are based on industry averages or general assumptions, multiples can provide misleading results. For example, if businesses in your industry often sell for 3x their revenue, you may be tempted to apply this rule for your company. However, these estimates often overlook a company’s unique strengths, risks, and financial performance. As such, relying on a generic number may cause owners to over- or underestimate the value of their business. Valuation multiples alone also fail to account for industry changes or market conditions. Obtaining a professional business valuation ensures that all key factors are considered when using valuation multiples.
The Role of a Business Valuation Expert
When performing a business valuation, a business valuation expert reviews financial data, market trends, and industry conditions. Additionally, they adjust for unique strengths or risks that generic formulas miss. This thorough process ensures a precise, fair market value estimate. By working with a certified valuation expert, business owners can reduce guesswork, avoid an inaccurate business valuation, and build trust among buyers and investors.
Conclusion
Knowing what multiple is used when valuing a company helps owners make informed financial decisions. Valuation multiples provide a simple way to estimate value based on market trends, but they must be applied carefully. The right multiple depends on factors such as the company’s size, profitability, and risk. Working with a valuation expert ensures the number accurately reflects fair market value.
As a professional business appraiser, Peak Business Valuation has the tools and expertise to determine what multiple is used when valuing a company. We are happy to help you better understand what is a valuation multiple and how it applies to a business appraisal. Begin today by scheduling a free consultation with Peak!
