This is part 1 of the series on business valuations. Here's the list of all articles in this series:
Part 1: The Mighty '8x Multiple' (You are here)
Quick question: What is the 8x multiple?
Quick answer: It’s a quick technique to calculate business valuation.
Example: A's business is earning $100,000 EBITDA per year. Quick valuation of A's business, at 8x multiple, would be $100,000*8 = $800,000.
Have I seen it in real life?
Not unless you know where to look. I have noticed it on Shark Tank many times. For instance:
Entrepreneur: Sharks, our EBITDA is $50,000 per year. We are looking to raise $100,000 for a 10% stake at $1,000,000 valuation.
Shark: I am willing to give you $100,000 for a 25% stake at $400,000 valuation. (Disclaimer: not an actual conversation on the Shark Tank show).
Noticed how the Shark used 8x multiple to calculate business valuation?
Okay, I am intrigued. What is it, really?
8 is the sum total of all discounting factors at 12.5% from year 1 to ∞. So, the present value of $1 after 1 year discounted at 12.5% would be (1/1.125)^1 = 0.8889. Similarly, the present value of $1 after 2 years would be (1/1.125)^2 = 0.7901. So on and so forth.
Let’s Nerd Out
As the number of years goes up to ∞, the present value would be too small. Let's calculate the sum of all present value factors:
Year 1: 0.8888888889
Year 2: 0.7901234568
Year 3: 0.7023319616
...
Year 350: 0.0000000000
Clearly, the sum is 8. I stopped at year 350, but you can calculate up to year 10,000 or beyond, the sum would still be 8.
In simple terms, please
In our Shark Tank example above, suppose the investor is looking for a 12.5% return per year. Then investing $400,000 would give her the $50,000 per year, that’s the business’ current EBITDA. Since the entrepreneur is requesting $100,000, the Shark would invest $100,000 for a 25% stake rather than for 10% stake (that the entrepreneur is proposing), so she can earn 25% of $50,000 i.e. $12,500 or 12.5% return on her $100,000 investment.
12.5% rate of return is generally accepted as a good return for risk associated with a business already earning positive EBITDA. Of course, you can use a different 'x' multiple for your perceived/calculated risk associated with the business. For example, the multiple would be 10x at a 10% discounting rate and 5x at a 20% discounting rate.
Terms and conditions apply, right?
Of course, the condition is that other things remain the same. The business must have a positive EBITDA to calculate the valuation. Also, it is assumed that the business will be able to achieve the same EBITDA year on year in perpetuity.
That's all for now, folks. Stay tuned for another post on how to calculate the valuation of a (currently) loss-making entity which has great growth potential or an early-stage startup, which is making nominal EBITDA but would grow exponentially in the near future.
If you have any questions, please leave a comment or feel free to contact me here.
