In my last newsletter entitled "EBITDA: Why Use It to Value Acquisitions?" we discussed why EBITDA is used for business valuations and some of the mechanics of estimating Enterprise Value by utilizing a multiple of Earnings Before Interest & Taxes ("EBITDA"). While the calculation itself is relatively straightforward, achieving a realistic approximation of Enterprise Value can be challenging given that EBITDA multiples can vary greatly!
The goal of any valuation approach is to assess the future earnings potential of the business. Higher EBITDA multiples are applied to companies with high future earning potential and low-risk predictable cash flows. Conversely, low EBITDA multiples are applied to companies with low future earning potential and high-risk unpredictable cash flows.
Multiples are affected by uncontrollable factors such as the economy, cost and availability of capital, regulatory environment, and more. Here we will focus on factors that can be controlled by management.
The following controllable factors are widely accepted to have a substantial impact on Enterprise Value:
Company Size
One of the most significant factors impacting valuation multiples is simply the company's size. In general, smaller businesses (with values between $10 - $25 million) have lower multiples of between 5.0x to 6.0x, and larger businesses (with values between $100 - $250 million) have higher multiples of between 7.0x and 9.0x.
Industry
Another factor impacting valuation multiples is the industry's attractiveness in which the business operates. 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.
Customer Concentration
Customer concentration refers to how much of a businesses' revenue comes from a limited number of customers. Firms with a large proportion of revenue coming from a small number of customers command smaller EBITDA multiples. Commonly, a company is considered to have high customer concentration when 15-20% or more of revenue comes from a single customer.
Strong Management Team or Key Man Risk
When a meaningful share of a business's success is tied to the inputs of one or two key employees, the business is said to have key man risk and commands a lower multiple. A strong management team is much more attractive to a potential buyer than a company that is solely dependent on its owner.
Growth
Companies that exhibit consistently higher historical revenue growth than the industry average and strong growth prospects warrant higher EBITDA multiples. Revenue growth at the expense of profitability can hurt valuation multiples. Firms that operate in stable or rapidly growing industry sectors are more valuable. Investors look for companies that are scalable and have high growth potential.
Recurring Revenue
Recurring revenue is defined as revenue that is highly likely to continue. Businesses with multi-year customer contracts or monthly subscription services are classic examples of contractually recurring revenue which is highly valued.
Profitability
Highly profitable companies demand higher valuation multiples. Three common profitability indicators are gross profit margin, EBITDA margin, and net income margin.
Factors Impacting the Quality of EBITDA
One-Time Events
One-time expense events should be added back, and one-time income events should be subtracted from EBITDA to develop a normalized EBITDA level. Owners' personal-related expenses (e.g., auto lease, country club memberships) should also be added back to EBITDA for smaller businesses.
Capital Expenditures
Suppose cash flow must continually be reinvested in capital expenditures. In that case, EBITDA is no longer a meaningful proxy of cash flow, so valuations can be adversely affected. In these instances, it may be more appropriate to use EBIT instead of EBITDA since annual depreciation and amortization can indicate the annual level of capital expenditures.
Cyclicality
Businesses that operate in highly cyclical industries (e.g., home building, construction, heavy equipment, luxury goods) are often impacted by macroeconomic trends 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 an entire business cycle (roughly 5.5 years). It may be more appropriate to use a two, three, or even five-year average EBITDA level when valuing the company. Volatility creates uncertainty leading to increased risk and a decreased valuation multiples.
Other factors that affect valuation multiples include the following:
- Access to capital
- Supplier concentration
- Supplier pricing advantage
- Product or service diversification
- The life cycle of current products or services
- Geographical distribution
- Currency risk
- Internal controls
- Business owner reliance
- Legal issues
- Years in operation
- Location
- Demographics
- Availability of labor
- Employee stability
- Internal and external culture
- Economic factors
- Industry and government regulations
- Political factors
- Fixed asset age and condition
- Strength of intangible assets
- Distribution system
- IT systems
- Technology life cycle
