If you are considering selling your business, you undoubtedly need to understand its value. Unfortunately, arriving at that answer can entail many different methodologies, and it often involves the familiar valuation formula of applying a multiple of Earnings Before Interest, Tax, Depreciation, and Amortization (EBTIDA).
For example, if a company boasts EBITDA of $1 million, and a five times EBITDA multiple is applied, the company’s estimated value is $5 million. But how do we know what multiple applies to your business? And how do we know if the EBITDA number is even accurate? After all, EBITDA will not be the same for every business.
Generally, higher EBITDA multiples apply to businesses with high future earnings potential and low-risk predictable cash flows. In contrast, lower EBITDA multiples apply to companies with low future earnings potential and high-risk unpredictable cash flows.
Using EBITDA multiples is not the only way to evaluate a company, although it’s a reasonably straightforward way. It is important to note that many factors can impact EBITDA multiples. So, what are some of these factors?
The Business Sector
The industry, or sector, in which your business operates can affect valuation multiples. Sectors can vary quite a bit based on different characteristics, such as industry trends, barriers to entry, and competition. As a result, valuation multiples differ as well. For example, if your business operates in a sector with favorable growth rates, higher barriers to entry, and less competition, it is likely to be valued at higher multiples.
The Size of the Business
The size of the company is a significant factor in its valuation. Typically, smaller companies are worth less and have lower multiples, and larger companies are worth more and have higher multiples. This is simply partly because something more significant is generally worth more and because smaller companies usually do not have the same level of resources and assets that larger companies do, such as economies of scale and access to capital. It is also simpler to complete one significant transaction than several small transactions.
How much of your company’s revenue comes from a given number of customers is another EBITDA multiple factors. A business with a substantial proportion of income stemming from a limited number of customers has high customer concentration and therefore commands lower EBITDA multiples, and vice versa. The impact on EBITDA multiples can vary and can be mitigated by certain circumstances, such as a long contract with a key client.
If your company’s performance is contingent on the contribution of one or two key employees, this is viewed as a risk and results in a lower multiple. It would help if you had a strong leadership team in critical functional areas of the business to minimize this risk. The loss of a vital employee can negatively affect a company’s revenue potential and erode its valuation.
Degree of Profitability
More profitable companies get higher valuation multiples and vice versa. Profitability can be measured by gross profit margins, EBITDA margins, and net income margins. Higher profit margins garner more revenue and get business owners higher rates of return on capital.
If your business demonstrates consistent historical revenue growth above the industry average or shows strong growth potential, it calls for higher EBITDA multiples. But it is important to remember that any revenue growth at the expense of profitability can negatively impact valuation multiples.
Recurring revenue is considered reliable income that is sustainable into the future. For that reason, multi-year contracts or subscription services are a good thing for increasing valuation multiples. However, suppose you have recurring revenue that is not under contract but has a solid history of occurring regularly. In that case, it can also be suitable for multiples but not as significantly as contractual revenue.
The Quality of EBITDA
EBITDA multiples are crucial to company valuations. But it’s equally essential that the EBITDA is accurate, which can be influenced by a few factors.
How much cash flow your company is expected to generate in the future is a significant valuation factor. Still, EBITDA is only valid for measuring cash flow when capital expenditures are low.
Sometimes a company can experience a one-time, non-recurring event, such as an insurance claim, loss on the sale of equipment, severance payments, or loss of a key customer. These past events should be added back or subtracted from EBITDA. Likewise, if your company is on the smaller side, your personal expenses as an owner should be added back to EBITDA.
If your company operates cyclically, it can be affected by macroeconomic trends outside of your control. Therefore, EBITDA for a given year may not accurately reflect the EBITDA average generated over an entire business cycle. In such a case, it may make more sense to apply a two- to five-year average EBITDA for valuation purposes.
The bottom line is that the value of a company is based on how much revenue it is expected to generate in the future, and calculating this can be a very delicate and complicated process. However, understanding EBITDA and its multiples can help you better understand the value of your business when taking it to market for a sale, even though other factors impact valuation beyond EBITDA. Regardless, it is beneficial to learn about the many aspects that influence the valuation of a company so that you can be in the best position for your business for a sale whenever you are ready.
Ready to Sell?
If you are ready to sell or just want to learn more about getting a valuation of your company, feel free to contact us at Benchmark International at your convenience. Talking business is what our M&A experts love to do. Let’s discuss how we can help you.
Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com
Europe: Michael Lawrie at +44 (0) 161 359 4400 / Enquiries@BenchmarkIntl.com
Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com
ABOUT BENCHMARK INTERNATIONAL
Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $8.25B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted thousands of owners with achieving their personal objectives and ensuring the continued growth of their businesses.