What is a Valuation Multiple?
Valuation multiples are most commonly known as market multiples. Market multiples are ratios comparing one financial metric (i.e. Share price) to another financial metric (i.e. Earnings per Share). Valuation analysts use multiples as financial measurement tools to compute the value of a company and compare it to similar companies.
Three common valuation multiples used to value small businesses include the revenue multiple, EBITDA multiple, and seller’s discretionary earnings (SDE) multiple. Below we will discuss each of these multiples in detail.
The revenue multiple is a ratio used to measure a company’s value based on its total sales. Applying this multiple by the most recent 12-month period of revenue will give you an implied value of the business. The calculation is as follows:
Revenue X Multiple = Value of the Business
For instance, if a company generates $650,000 in revenue and transacts at a 0.46x multiple, then the business value is worth approximately $299,000.
$650,000 X 0.46x = $299,000
This calculation is straight forward. However, some companies do not transact on a revenue multiple. The reason being, a revenue multiple does not take into consideration the operations of a business. As such, this multiple may not be relied upon. Therefore, it is important to look at cash flow multiples. Cash flow multiples consider expenses that impact the cash flow. For instance; rent, COGS, and salaries.
EBITDA is earnings before interest, taxes, depreciation, and amortization. The EBITDA multiple measures a company’s return on investment (ROI). This gives you an approximate estimate of cash flow or operating profit. By applying this multiple to EBITDA you get an implied value of the business. The calculation is as follows:
EBITDA X Multiple = Value of the Business
For example, a company has an EBITDA of $750,000 and transacts at an EBITDA multiple of 2.81x. Using the above metrics, the company is worth approximately $2.1M.
$750,000 X 2.81 = $2,107,500
This multiple is preferred as it is normalized for differences in capital structure, taxation, and fixed assets. Normalized ratios allow for comparisons to similar businesses. Normalization is the process of removing non-recurring expenses or revenue from a financial metric like EBITDA, EBIT or earnings. Once earnings have been normalized, the resulting number represents the future earnings capacity that a buyer would expect from the business.
Seller’s Discretionary Earnings Multiple:
The SDE multiple measures the cash-flow of business earnings. This multiple is applied to SDE for a business to derive an implied value of the business. The calculation is as follows:
SDE X Multiple = Value of the Business
For example, if a company reports seller’s discretionary earnings of $350,000 and transacts at a 2.6x multiple, then the business is worth approximately $910,000.
$350,000 X 2.6x = $910,000
Seller’s discretionary is a common cash flow multiple used in small business transactions. SDE is derived by starting with your company’s EBITDA and adding back potential expenses that would not otherwise be incurred by a new owner. These expenses may include owner’s compensation, manager’s salary, other expenses such as auto, and nonrecurring items or events such as legal fees, consulting.
This approach is most frequently used as a valuation method for small businesses with sales of less than $3M.
Using Valuation Multiples
Multiples are very useful in valuation as they provide valuable information about a company’s financial status. This analysis can then be used to make strategic and investment decisions. Multiples are also very simple and easy to use for most individuals.
However, multiples must be applied appropriately. Depending on the industry and business, different multiples may be more applicable. When using multiples, be sure to consult with a valuation professional to determine what analysis would be best for your company.
Also, be cautious as oversimplification can lead to misinterpretation and poor decision making. A valuation expert can help you break down various factors that impact your business value and discuss how to increase that value.
Lastly, know that multiples represent a specific time period of a company. They do not easily show how a company grows or progresses. Multiples are for short-term use, not long-term, as such the value of your business is constantly changing.
If you are looking for further information or specific multiples for your company, Peak Business Valuation is just a call away. We work with small business owners to know, understand and maximize their business value. Questions are always welcome! Please reach out via email or through a phone call.Schedule Your Free Consultation Today!