Why should you know the value of your business?
Valuing a business can be a daunting task involving art and science. However, as a business owner, it’s essential to know how much your company is worth for reasons such as:
- Selling your business: if you are thinking of an exit, knowing how much your company is worth and what levers you can pull to maximize its value is crucial to getting paid top dollar.
- Obtain additional financing: in case of potential funding from external parties (e.g., private equity), understanding your business’s actual value upfront will significantly help during the negotiations.
- Expanding your business: when investing heavily in organic growth or mergers and acquisitions (M&A), it’s crucial to determine the starting value of your company. By doing so, you can better evaluate your future actions’ impact and understand which ones will maximize your firm’s value.
As you will see in the following sections, you can estimate the value of your business in several ways. Besides valuation multiples, other approaches, such as discounted cash flow (DCF), are also commonly used. There is no one-size-fits-all valuation technique. Rather, the given circumstances, such as your company’s financials or objective of the valuation, will dictate which method is the most appropriate to use.
While obtaining a ballpark valuation may seem straightforward, it’s best to rely on advisors’ expertise when confronted with significant financial decisions, such as selling your business. By doing so, you can rest assured that you will receive proper compensation for your company’s value.
Valuation multiples: what are they, and why are they used?
Valuation multiples are ratios that reflect a company’s value (also known as enterprise value or market value) in relation to a specific financial metric such as EBITDA or revenue. In the case of a public entity, valuation multiples can also be used to estimate the company share price, with ratios such as price-to-earnings (P/E) and price-to-book (P/B).
Valuation multiples are standardized financial metrics that facilitate value comparisons within a peer group once adjusted for differences in characteristics, such as size or growth rate. A peer group can consist of companies in the same industry or in different industries but with similar financial and operational characteristics.
Investment bankers, investors, and other financial analysts like to use valuation multiples because it’s a quick and efficient way to compare a company’s value to that of a similar business. Compared to other valuation methods, such as discounted cash flow, the calculation, and interpretation of valuation multiples are usually much more straightforward.
Valuation multiples are readily available for listed companies on financial databases such as Bloomberg or Capital IQ. However, private company valuation multiples are usually more difficult to get, and often you have the make the calculation yourself.
Types of valuation multiples
At a high level, there are two categories of valuation multiples; enterprise value (EV) multiples and equity value multiples. Below are some commonly used EV and equity value-based multiples.
With equity value multiples, you are looking for the company’s share price. Therefore it only applies to listed companies whose share trades on the stock market. This blog post will primarily focus on the enterprise value multiples.
When applying an EV multiple, you are calculating the total value of the business, and therefore it can be applied to private companies as well. The EBITDA multiple is the most used enterprise value multiple, followed by the revenue multiple.
Why should you use the EBITDA multiple?
Starting with the basics, the EBITDA multiple is calculated by dividing a company’s enterprise value by its EBITDA. The EBITDA used can either be “trailing” (using the last 12 months) or “forward-looking,” where the projected next year’s EBITDA is used. Best practice dictates calculating trailing and forward multiples and comparing the resulting values.
The EBITDA multiple is popular among financial professionals because 1) the EBITDA is independent of the company’s capital structure (split between equity and debt financing), so it allows to compare companies with varying debt levels, and 2) it focuses on the actual underlying cash-generating potentials of the company and is less impacted by accounting decisions (e.g., depreciation and tax).
While the EBITDA multiple is the most used approach among enterprise value multiples, there can be occasions when other valuation multiples are more suitable. The revenue multiple, for example, is more appropriate for start-ups that focus on their growth rate over profitability or when a company is operating at a loss (negative EBITDA).
When to use the revenue multiple?
The revenue multiple is another widely used approach, and often it’s the only valuation multiple that gets reported in M&A transactions involving private companies. It’s calculated by dividing a company’s enterprise value by its trailing or forward-looking 12 months’ revenue.
As stated earlier, there can be instances, such as when analyzing start-ups or unprofitable companies, when using revenue over EBITDA is more appropriate. However, in most cases, finance professionals prefer the EBITDA multiple because it provides a more comprehensive view of a company’s financial performance.
Other types of valuation multiples that you can use
You may use EBIT over EBITDA when analyzing businesses with significant depreciation and amortization. This can be the case with asset-heavy industries such as industrials and energy. Depreciation and amortization are a proxy for actual cash expenses (capex) associated with utilizing assets that must be replaced or augmented over time. Therefore, you may not want to “ignore” them when valuing your business and use EBIT over EBITDA.
We can also use free cash flow or FCF as the denominator in our valuation multiple equations. EBITDA is a good proxy for FCF, so in most cases, analysts stick with EBITDA. However, when the company has significant share-based compensation (included in FCF but not in EBITDA), using FCF may be more appropriate to account for the “hidden expense” associated with this compensation method. If the company wants to avoid diluting existing shareholders, it will eventually have to use cash to buy back its shares.
The FCF may also be used over EBITDA for companies with significant investment requirements (e.g., most asset-heavy industries) or when a company capitalizes most of its expenses. That is because FCF is adjusted for capex while EBITDA is not.
A step-by-step guide to valuing your company using the EBITDA multiple
In this section, we will walk through the four main steps of finding the enterprise value of your business using the EBITDA multiple. Step 5 is for calculating the market value of equity of your firm, an important step in the context of M&A. The market value of equity is derived from the EV, and it represents the actual amount a buyer will pay for your business if you decide to sell it.
- Calculating the EBITDA of your business
- Make the necessary adjustments to your calculated EBITDA
- Find the EBITDA multiple based on peer group or historical valuations
- Calculate your company’s enterprise value
- Deriving your company’s market value of equity from EV
Step 1: Calculating the EBITDA of your business
EBITDA is a non-GAAP and non-IFRS metric; therefore, it may not be readily available for your business. Using your company’s income statement, EBITDA can be estimated using a top-down (revenue minus operational expenses) or bottom-up (net income plus tax, interest, depreciation, and amortization) approach. Either method is accepted, but investment bankers usually apply the top-down approach as it gives a better insight into the company’s main revenue and costs drivers.
Step 2: Make the necessary adjustments to your calculated EBITDA
This is a more challenging step as opinions differ on what should be added back to EBITDA. Usually, it’s a case-by-case situation, but these are some of the items that you should closely examine and adjust if needed:
- Your salary and perks
- The salary and perks of any family members to market value
- Market rent price if you are the owner of the facilities and don’t pay for it
- Personal expenses (e.g., mobile phone, childcare, travel expenses)
- Expenses or income that isn’t expected to continue after the sale
- One-off events
- Discontinued operations
Adjusting EBITDA helps obtain a normalized and accurate figure not impacted by irregular gains, losses, and other factors. Failing to adjust EBITDA may result in an incomplete representation of your company’s true earnings potential, leading to a lower valuation.
Step 3: Find the EBITDA multiple for valuing your company
Estimating the right EBITDA multiple that you should use to value your business is difficult, especially if you are looking for private company valuation multiples. Therefore, it’s best to rely on advisors’ expertise for this task. Common approaches to finding the suitable EBITDA multiple are the following:
Comparable company analysis: this approach is commonly used by investors and looks at the median or mean EBITDA multiple of your business’s industry or peer group. Deep industry knowledge and thorough research is required to find the right comparable companies to include in the calculation. Also, the resulting EBITDA multiple may need to be adjusted for differences in characteristics and operations.
Precedent M&A Transactions: this approach is generally applied when valuation is for M&A purposes, and it looks at the valuation multiples used in your preceding transactions. It can be applied if many recent transactions of companies with similar size and scope to your business have taken place. However, it’s important to remember that financial details for private company deals may be limited, and adjustments must be made to account for any premiums paid for potential synergies.
Historical analysis of your business’s EBITDA multiple: this approach involves analyzing the historical multiple of your business and can be a good approach if you want to get a quick estimation of your company’s current value. Historical valuation multiples will likely be available if your company had, for example, multiple financing rounds by venture capital and private equity firms. However, it’s important to note that adjustments will still need to be made to account for any notable changes in the industry or your company’s characteristics and operations
Step 4: Calculate your company’s enterprise value
You are at the finish line, it’s time to step through. Multiply your company’s adjusted EBITDA with the EBITDA multiple to determine your business’s enterprise value.
Enterprise value is a heavily used term in this blog post, so it’s essential that you have a good understanding of its definition. EV represents the comprehensive value of a company, and it’s arrived at by adding up the market value of your company’s debt and equity and then subtracting the cash and cash equivalents. If your company has any preferred shares or minority interests (also known as non-controlling interest), then these also need to be added when calculating EV.
Step 5: Deriving your company’s market value of equity from EV
In the context of M&A, it’s important to know your company’s market value of equity as, in most cases, this is the amount that you will receive if you decide to sell your business. To calculate this value, you’ll need to work backward, employing the EBITDA multiple to determine the enterprise value and subsequently adjusting it for the company’s net debt (the difference between its debt and cash) and any preferred equity or minority interest that may exist.
In the following sections, we will explore the drivers of valuation multiples, the pros and cons of relying on them, and what is considered a “good” valuation multiple.
Drivers of valuation multiples
The drivers of valuation multiples of public and private companies can be approached from two angles. First, we can analyze the drivers of the individual financial metrics that go into the equation as the numerator or denominator. With the EBITDA multiple, for example, drives can include accounting differences and what adjustments are made to EBITDA.
The second angle is a more birds-eye view. These drivers are generally applicable independently of which valuation multiple we use and include:
- Company fundamentals: companies with stable cash flows that are expected to grow faster than peers or are more profitable will generally have higher valuation multiples.
- Company size: larger companies are usually valued at higher multiples as they typically have more resources and a stronger market position.
- Risk: can be measured by volatility in the company’s earnings or debt levels (leverage); companies perceived as less risky are typically valued higher.
- Industry dynamics: companies operating in industries with favorable dynamics, such as high barriers to entry, substantial competitive advantages, or growing demand, are typically valued higher.
- Market sentiment: valuation multiples can be heavily affected by overall market sentiment, especially during uncertain economic times.
Besides the drivers listed above, in M&A transactions, the deal size and geography will also have profound implications on valuation multiples. For example, in our IT Services Valuation Multiples blog post, we found that within this industry, valuation multiples used in small transactions (less than $5M) were half of what was used for deal sizes in the $50M to $100M range.
Pros and Cons of valuation multiples
Valuation multiples are a useful tool to find your business’s value, but it’s important to understand its limitations. Below we collected the main advantages and disadvantages of relying on this approach.
- Simplicity: compared to other valuation methods, valuation multiples are generally easier to calculate and interpret. Among investment bankers and other financial professionals, it’s often the go-to approach when looking for a quick back-of-the-envelope value.
- Flexibility: valuation multiples can be applied to various industries. Valuation multiples are also “flexible” in selecting the numerator and denominator in the equation, and therefore, you can formulate industry-specific ratios.
- Comparative analysis: multiples analysis allows you to compare your company’s value to its peers. Doing so lets you see which competitors are valued at a premium or discount relative to your business.
- Market-driven: multiples reflect the market’s perception of your company’s value. As such, they can provide a valuable indication of what investors can be expected to pay for your business.
- Simplistic approach: The simplicity of valuation multiples can also be considered a drawback in some cases. This valuation approach omits multiple factors that can affect a company’s value, such as the quality of management. Also, it’s less flexible in analyzing different scenarios than the DCF approach.
- Limited comparable companies and transactions: if your business operates in a niche industry, the peer group may be too small to draw a meaningful conclusion about the median or mean valuation multiple. Also, data on private company valuation multiples may be limited. In the context of M&A, the number of preceding transactions may be insufficient to provide a reliable benchmark for valuation purposes.
- Subjectivity: valuation multiples involve making subjective assumptions, such as defining the peer group and adjusting for the difference in characteristics and operations. As a result, others can end up with values that differ from your calculation.
What is a good valuation multiple value?
Now you may ask the question; what is a good EBITDA multiple? A low EV-to-EBITDA ratio compared to peers may mean your company is undervalued, whereas a high EV-to-EBITDA ratio may signal overvaluation. However, there are no set rules on determining a low or a high EBITDA multiple because the answer is contingent on the industry in which your business operates. Therefore, interpretations of valuation multiples are all relative and require more in-depth analyses before deciding whether a company is undervalued, fairly valued, or overvalued.
The median EBITDA multiple of public companies
Using the FTSE All-World Index, the chart below shows the change in the median EBITDA multiple across the different GICS sectors over time of listed companies. Financials are excluded as the EBITDA multiple is not an appropriate metric to value banks, given the differences in operations and accounting.
It’s important to highlight that you should not use these figures as reference points when calculating your own business’s valuation multiple. Rather, it is to give you a high level of understanding of which sectors have the highest/lowest EBITDA multiples and how these values change during market environments.
Other valuation methods
Besides the enterprise value multiples and equity value multiples, you can apply several other approaches to find the value of your business. These valuation methods can also be applied to private companies, and the given circumstances should dictate your approach selection by considering factors such as:
- What stage is your company in (start-up, growing, mature, etc.)
- Your company’s financials (some valuation methods may not be appropriate when historical performance is very volatile)
- The industry your company operates in
- Available information on the market and competitors
- The objective of the valuation (M&A, external investment, etc.)
If you decide to calculate the value of your business using another valuation approach, below are the most used alternatives.
Discounted cash flow: DCF values a business based on its expected future cash flows discounted to present value. This approach requires many assumptions, such as expected growth rate, discount rate, and future capital expenditure and working capital requirements.
Asset-based valuation: Asset-based valuation values a business based on net assets and is most suitable for tangible asset-heavy businesses. It involves estimating the value of the company’s assets, including tangible assets (such as property, plant, and equipment) and intangible assets (such as patents and trademarks), and subtracting its liabilities’ value.
Replacement cost method: The replacement cost method values a business based on the cost of replacing its assets. It involves estimating the cost of replacing the company’s assets with similar new assets and adjusting for depreciation. This approach is advantageous when valuing companies that own specialized assets that are not traded on a public market and do not have readily available market prices.
Each method has strengths and weaknesses. Best practice dictates estimating your business’s value with multiple approaches and comparing the results to arrive at your final value. For achieving the best outcome in complex financial scenarios, such as M&A or fundraising, it’s strongly recommended to rely on advisors’ expertise to find the value of your business.
About Aventis Advisors
Aventis Advisors is an M&A advisor focusing on technology and growth companies. We believe the world would be better off with fewer (but better quality) M&A deals done at the right moment for the company. Our goal is to provide honest, insight-driven advice, clearly laying out all the options for our clients – including the one to keep the status quo.
Get in touch with us to discuss how we can help you in the sale or acquisition of a business.