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If you are thinking about selling your company, you are undoubtedly wondering what’s the value of your business. A common approach used to estimate the value of a business is to apply a multiple of Earnings Before Interest, Tax, Depreciation, and Amortization (EBTIDA). For example, if a business generates EBITDA of $1 million and a 5.0x EBITDA (“five times EBITDA multiple”) is being applied, then the estimated value of the business is $5 million (e.g., $1 million multiplied by 5). The math is simple enough. But how do you know if the business should be valued at 5.0x EBITDA or some other multiple? Further, how do you know if EBITDA of $1 million is an accurate number? As with most things, the devil is in the details. In practice, not every business is worth 5.0x EBITDA. Some are worth quite more and others quite less. Further, not all EBITDA is created equal. High-quality EBITDA converts dollar-for-dollar to cash flow, while low-quality EBITDA converts to cash at a lower rate. In this article, I aim to help business owners better understand what factors impact the value of their business and in turn what they can realistically expect to sell their company for. I begin by discussing seven common factors affecting EBITDA multiple levels and conclude by reviewing three common factors that impact the quality of EBITDA.
Seven Factors Affecting EBITDA Multiples
Many investment bankers, private equity funds, and banks value companies using a multiple of EBITDA. The resulting value after applying the multiple is often referred to as the Enterprise Value, or the value of the company including debt and excluding cash. EBITDA multiples are not the only way to estimate the value of a company, but it is often the most straight forward. Regardless of the method chosen, the goal of any valuation approach is to make an assessment of the future earnings potential of the business. In general, higher EBITDA multiples are applied to companies that have high future earning potential and low-risk predictable cash flows. Similarly, low EBITDA multiples are applied to companies that have low future earning potential and high-risk unpredictable cash flows. Seven common factors affecting the future earnings potential of a business and in turn the EBITDA multiple used to value the company are discussed below (in no particular order).
Company Size
It turns out that one of the biggest factors impacting valuation multiples is simply the size of the company. In general, smaller businesses (with transaction values between $10 - $25 million) are worth less and have lower multiples of between 5.0x to 6.0x, and larger business (with transaction values between $100 - $250 million) are worth more and have higher multiples of between 7.0x and 9.0x. This is because small businesses typically lack many of the resources and advantages available to large businesses, including access to capital and economies of scale. A summary of how EBITDA multiples vary by business size between 2016 and 2018 is presented below.
Industry
Another factor impacting valuation multiples comes down to simply how attractive the industry is in which the business operates in. Characteristics such as industry growth trends, barriers to entry, and level of competition vary dramatically by industry and as a result valuation multiples do too. In general, a “rising tide lifts all boats” applies. Companies that operate in industries with attractive growth rates, high barriers to entry, and less competition tend to be valued at higher multiples than companies in other industries. A summary of how EBITDA multiples vary by industry between 2003 and 2018 is presented below.
Customer Concentration
Customer concentration refers to how much of a businesses’ revenue comes from a given number of customers. In general, businesses with a large proportion of revenue coming from a limited number of customers are considered to have high customer concentration and command smaller EBITDA multiples, while businesses where no one customer accounts for a meaningful proportion of revenue are considered to have low customer concentration and command higher multiples. What proportion of revenue constitutes high concentration is subjective. Commonly, a company is considered to have high customer concentration when 15-20% or more of revenue comes from a single customer. The ultimate magnitude of how customer concentration influences EBITDA multiples can vary. The impact of customer concentration on multiples can be mitigated when the business has a multi-year contract with a customer or if a customer has high switching costs.
Key Man Risk
When a meaningful share of a businesses’ success is tied to the inputs of one or two key employees the business is said to have key man risk and as a result commands a lower multiple. This often occurs when there is not a strong supporting management team in key functional areas like sales, operations, and or accounting. It is most common in smaller, founder-owned and operated businesses in which the owner is the face of the firm, has all of the customer relationships, and makes all key business decisions. The loss of a key employee can have a devastating impact on a businesses’ earnings potential and replacing this employee, if possible, often takes time and effort causing the business to be worth less.
Growth
Companies that exhibit consistently higher historical revenue growth than the industry average and/or that can demonstrate strong growth prospects warrant higher EBITDA multiples, while companies exhibiting lower historical revenue growth and/or facing deteriorating growth prospects tend to warrant lower EBITDA multiples. However, not all growth is considered equal. Revenue growth at the expense of profitability can hurt valuation multiples.
Recurring Revenue
Recurring revenue is defined as revenue that is highly likely to continue in the future. Businesses with multi-year customer contracts or that offer monthly subscription services are classic examples of contractual recurring revenue. Contractual recurring revenue is the most coveted type as it increases revenue visibility and can significantly increase valuation multiples. Not quite as strong as contractual recurring revenue is customer revenue that has historically occurred on an annual basis but that is not protected by a contract. While this is a strong indication of the stickiness of the customer relationship, it does not command as significant of an increase in valuation multiples as contractual revenue does.
Profitability
Highly profitable companies demand higher valuation multiples, while less profitable companies demand lower valuation multiples. Profitability can be measured in multiple ways. Three common indicators of profitability are gross profit margin, EBITDA margin, and net income margin. Companies with higher profit margins earn more money on each dollar of revenue and in turn earn business owners higher rates of return on their capital.
Three Factors Impacting the Quality of EBITDA
Knowing the right EBITDA multiple to apply in a business valuation is only half of the battle. Just as critical is determining an accurate EBITDA to use. Convention dictates using the last-twelve-month EBITDA (LTM EBITDA). However, for various reasons, LTM EBITDA is often not representative of the future earnings potential of a business – which is what matters. This may be because the company experienced a one-time event in the last-twelve months that is not expected to recur or simply because EBITDA does not convert to cash flow at a high rate. In practice, it is quite common to calculate a normalized EBITDA by making adjustments for one-time events, taking a historical average, and in some situations, not using EBITDA at all. Three common factors that influence what EBITDA to use are presented below (in no particular order).
One-Time Events
In any given year, a business may experience events that qualify as non-recurring or one-time. Classic examples of non-recurring items include the gain or loss on the sale of a piece of equipment, litigation fees, severance payments, insurances claims, and/or the loss of a material customer. Truly one-time events should be added back (e.g., one-time expenses) or subtracted from (e.g., one-time income) EBITDA to come up with a normalized level of EBITDA. For smaller businesses, owner’s personal-related expenses (e.g., auto lease, country club memberships) should also be added back to EBITDA. It may also be appropriate to adjust expenses that are considered above or below fair market value like a non-arm’s length lease agreement with real estate owned by the owner.
Capital Expenditures
At the core of any business valuation is how much cash flow that business can be expected to generate in the future. Investors and operators have often turned to EBITDA as a quick and dirty indicator of how much cash flow a business generates. However, EBITDA is only a useful measure of cash flow when capital expenditures are low. Capital expenditures include things like the purchase of machinery and equipment and are ultimately not accounted for in EBITDA. If the cash flow a business generates must continually be reinvested in capital expenditures, then EBITDA is no longer a meaningful proxy of cash flow and the valuation of that business should reflect that. In these instances, it may be more appropriate to use EBIT instead of EBITDA, since annual depreciation and amortization often provide a decent indication of the annual level of capital expenditures required by the business.
Cyclicality
Businesses that operate in highly cyclical industries (e.g., home building, construction, heavy equipment, luxury goods) are often impacted by macroeconomic trends that are outside of management’s control. For these companies, EBITDA for any given year may not represent a very accurate picture of the average level of EBITDA the business generates over a full business cycle (roughly 5.5 years) and thus its future earnings potential. In these instances, it may be more appropriate to use a two, three, or even five-year average EBITDA level when valuing the company.
Summary
At its core, the value of a business is based on how much money that business can be expected to generate in the future. Determining the businesses’ earnings potential and in turn value is often more art than science. While the above lists are not exhaustive, understanding the myriad of factors that affect EBITDA multiples and the accuracy and quality of EBITDA can help a business owner better understand the value of their business and in turn, what they can realistically expect to sell their company for. In practice, the ultimate test of how much a company is worth is extremely business specific, is impacted by the health of the broader economy, and boils down to the highest price a business owner is able to negotiate for the sale of their business. Various other factors influence valuation that are not covered in this article including taxes, certainty and timing of close, and the creditability and trustworthiness of the buyer. In any event, it pays to understand the ins and outs of the various factors that impact a business’s valuation.
The partners at Cronkhite Capital have over 10 years of experience buying and selling small to medium sized businesses across industries. If you are interested in learning more about the types of companies Cronkhite Capital buys or have questions about the typical sales process, please reach out directly to Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103.
