In last month’s article, we discussed valuation methodologies and some of the ways in which you may gain insight into the value of your own business. In this month’s article, we examine a valuation subject misunderstood by most and loved by many, purchase price multiples.
Typically, in our M&A advisory business, conversations with buyers and sellers begin as follows:
Buyer/Seller: “So Jim, what types of purchase price multiples are good businesses selling for these days?”
JAZ: “That depends upon the business, there are many factors to consider.”
Buyer/Seller: “C’mon, Jim, can’t you give me a simple ‘rule of thumb’ multiple to use to value businesses?”
We truly wish valuing businesses was as easy as applying a simple rule of thumb. Life for buyers and sellers would be much easier.
Unfortunately, since we live in the real world, using purchase price multiples to value businesses is an inexact science at best and a dangerous, misleading process at worst. How can purchase price multiples be potentially dangerous to business owners?
The story of a recent discussion with a prospective client demonstrates a major problem with purchase price multiples. When speaking with the CEO of a company heavily involved in managed print services, he said, “Xerox is trading at 8.4 times EBITDA. Our company has $400,000 of EBITDA, so we should be able to sell for $3.4 million, the same multiple as Xerox since we’re in the same business.” Is it fair to assume the earnings multiple of Xerox, with annual sales of $21 billion and EBITDA of $2.6 billion is relevant and/or analogous to a one-location MPS company with annual sales of $1.7 million and EBITDA of $400,000? Problem here is the owner of the MPS business is convinced the 8.4 EBITDA multiple is right for his business. This means, if he does try to sell his business, he may be in for a disappointment.
Yes, this is an extreme example, but it clearly illustrates the challenge of using multiples to value your business. There are even more challenges, as the examples below will show.
First, take a look at the basic financial data in Table 1 below:
| Table 1 | Company A | Company B |
| Sales | $3,000,000 | $3,000,000 |
| EBITDA | $300,000 | $300,000 |
Using a multiple of earnings method, based on the information in Table 1, we would assume Company A and Company B would sell for exactly the same price since their revenues and EBITDA are the same. But, more about the two companies may change your mind about identical values:
| Table 2 | Company A | Company B |
| Business Type | 3 location equipment dealer | 1 location equipment dealer |
| Total customers | 600 | 300 |
| Sales | $3,000,000 | $3,000,000 |
| EBITDA | $300,000 | $300,000 |
Based on the additional information in Table 2, do you think these two companies are still worth the same? Company A has multiple locations and a much larger customer base. Company B has only one location and while it has a smaller customer base, its customers are larger than Company A.
Let’s take this a step further: we’ve added more information about the two companies in Table 3 below:
| Table 3 | Company A | Company B |
| Business Type | 3 location equipment dealer | 1 location equipment dealer |
| Total customers | 600 | 300 |
| Sales | $3,000,000 | $3,000,000 |
| EBITDA | $300,000 | $300,000 |
| Sales growth | 5% | 23% |
| EBITDA | 3% | 30% |
As you can see in Table 3, while both companies have identical sales and earnings, Company A grew at only 5% in sales and just 3% in earnings from the prior year while Company B grew at a significantly faster rate. Are these two companies still worth the same amount of purchase price?
Finally, take a look at Table 4 below for even more information on these two businesses:
| Table 4 | Company A | Company B |
| Business Type | 3 location equipment dealer | 1 location equipment dealer |
| Total customers | 600 | 300 |
| Sales | $3,000,000 | $3,000,000 |
| EBITDA | $300,000 | $300,000 |
| Sales growth | 5% | 23% |
| EBITDA | 3% | 30% |
| Management | Will stay after a sale | Retire immediately |
| Customer concentration | No | Yes |
| Exclusive Territory | No | Yes |
Table 4 shows Company A has a management team who will remain in place after a sale, has no customer concentration issues, but has no exclusive territory while Company B’s management will retire immediately after a sale, has a customer concentration issue (which may be exacerbated by the retirement of the owners) but it does have an exclusive territory for its products. Are these companies worth the same amount?
As you can see, using only a purchase price multiple based solely on earnings or revenues, the math would say these companies are worth the same, but once you “open the lens” and look beyond sales and earnings, we think the eyeball test says these companies are not valued equally…something contrary to multiples.
ONE SIZE DOESN’T FIT ALL
The reason we at CFA always give a qualified answer to the seemingly basic question: “What’s a good purchase price multiple to value my business,” is because there are so many variables in the equation; there is not a “one-size fits all” solution. As we illustrated in the tables above, the following factors greatly influence purchase price decisions…but are not accounted for in simple multiples of earnings or revenues when valuing businesses:
- Size of the company: Generally speaking, larger companies with more profits command a higher multiple than smaller companies in the same industry.
- Industry: The industry you are in impacts multiples. Manufacturers of proprietary products generally sell for a higher multiple than distributors of products…and size of each matters within the industry.
- Balance sheet: A company with more leverage available on its assets will generally sell for a higher multiple than an “asset-light” company.
- Growth: Companies who can show sustainable, continued growth will trade at a higher multiple than companies with limited growth in sales or earnings.
- Customers: Companies with no customer concentration issues (i.e., no more than 18% of sales from one customer and/or no more than 50% of sales from 3 or 4 customers) will command a higher multiple.
- Products: Companies who produce or sell proprietary products get higher multiples. Companies who produce or sell commodity items/products have lower multiples.
- Vendors: If your company gets more than 35% of its products from one vendor, this reliance on a single vendor may lower your purchase price multiple.
- Management: A company with a good management team in place who will remain after a sale ALWAYS commands a higher price or multiple than a company where key players retire or exit the business upon a sale.
- Technology/Equipment: Companies who have not invested in and/or updated their equipment, software systems, machinery, and/or technology have lower purchase price multiples.
- Financial data: Companies who have audited or reviewed financial statements and who can provide current, relevant, reliable data about the business’ finances and operations will command higher purchase price multiples.
Unfortunately, as you can see, there is no simple, easy way to value your business with a single, straightforward purchase price multiple. That’s why we always say “it depends,” when asked to opine on an appropriate multiple for a business. I am always reminded of a mentor of mine who once said: “Rules of Thumb for valuing businesses are best used when valuing thumbs.”
End of the day, while we at CFA have a very good idea of the range of multiples appropriate for businesses in the imaging industry, without a thorough dialog about the business, any discussion on specific multiples becomes less than meaningful and may provide owners with the wrong impression—high or low—about the value of their business.
If you have specific questions about how your business would be valued and about current deal multiples, we are happy to discuss these with you personally.
To those who insist on using multiples to value businesses without considering factors beyond sales and earnings we have two words of advice: Caveat Emptor.
Next month, we’ll discuss another subject close to our hearts: The 10 Biggest Mistakes Business Sellers Make.
