When you look at company valuations, they’re often presented as a multiple of some metric. Common metrics include: EBITDA, EBIT, NOPAT, sales, and book value. For example, Widget Inc. may currently have a market value of 6x EBITDA, meaning the company is valued at six times that of earnings before interest, tax, depreciation, and amortization expenses (EBITDA). As a business owner, it might seem irrelevant what multiple of EBITDA your business is when you own an early-stage company that is still trying to turn a profit. Depending on the multiple you choose, the valuation could widely vary. Admittedly these multiples don’t account for intrinsic value, such as growth or innovation, and yet they are widely used by industry professionals. The biggest reason for this is because valuation multiples are a fast, easy way to get an idea of how much a business is worth without doing extensive, costly research.
Let’s take a look at one example of how valuation multiples work. Suppose you look at Company A and Company B – you might notice they both have revenues of $100 million and positive operation cash flows of $120 million. However, they’re valued at different multiples of earnings before interest and tax expenses (EBIT). Why’s this? Well, by the time you take out operating expenses, depreciation, and amortization from your revenues, you find out that one is more profitable than the other. This doesn’t mean that one is bringing in more cash than the other. It might only be because Company A has more fixed assets to depreciate each year, or perhaps Company B leases its offices and therefore has less fixed assets to depreciate. Whatever the case may be, choosing the right multiple determines what to compare. If you don’t want to compare deprecation expenses, then EBITDA may be a better metric.
It is also common to see a business valued as a multiple of earnings. For example, Google’s common stock is priced around $575/share and has earnings per share of $19. Thus, it is valued at a Price/Earnings multiple of 30 (575/19). While this can be a quick, easy way to compare Google with Apple and Microsoft, earnings multiples also have their limitations. If one company has more debt to pay off than another but is comparable in value, then the interest expense will lower its earnings multiple and throw off the valuation.
Often multiples are used to see how much your business can sell for in the market. Valuation firms will choose a list of comparable companies and the valuation multiples at which they’re valued, giving you an idea of how much you can expect to sell for. When choosing comparable companies it’s important to consider: company size, products and services, growth rate, number of employees, customer segmentation, location, and economic drivers. For example, a window manufacturer may be comparable to a roofing supplies manufacturer because they both profit from the housing industry. Remember, though, that these multiples are relative and there is still plenty of value to negotiate in an acquisition.
Whatever industry you look at, companies will vary widely in debt structure, fixed assets, patents, and operating expenses, etc. Therefore, you should choose the multiple that best allows you to compare companies that are, indeed, comparable. Valuation multiples are supposed to be simplistic and give you an idea of what your business is worth. It is more of an art than a science.