Business values are often estimated based on a “multiple” of earnings, revenue, or other financial metrics. For example, business owners often hear that a company is worth three, four, or five times its annual earnings. But where do these multiples come from?
A business valuation multiple is generally developed from market evidence (including sales of comparable businesses) and adjusted based on the financial performance, risk factors, and other characteristics of the company being valued.
Because valuation multiples are adjusted for each situation, there is no single multiple that applies to every business, even within the same industry or between similar businesses.
A valuation multiple is a ratio used to estimate business value based on a financial metric, such as EBITDA (earnings before interest, taxes, depreciation, and amortization) or Seller's Discretionary Earnings (SDE).
To give a simplified example: suppose a business generates $300,000 in annual EBITDA. Applying a valuation multiple of 4.0 would produce an indicated business value of $1.2 million.
$300,000 EBITDA × 4.0 valuation multiple = $1,200,000 indicated business value
The calculation is straightforward. The challenge is deriving the $300,000 earnings figure from a complex business financial picture, and deciding whether a multiple of 4.0 is supported by the market and the characteristics of the business being valued.
It is important to understand what the resulting value represents. For example, an EBITDA multiple commonly indicates enterprise value rather than the value of the owner's equity. Debt, excess cash, and other adjustments may be necessary to determine equity value.
Business appraisers typically develop valuation multiples by analyzing sales of comparable businesses.
Transaction databases contain information about completed business sales, including selling prices, revenue, earnings, industry classifications, and other financial information.
An appraiser may calculate the relationship between the selling price and an appropriate earnings metric for each comparable transaction. For example, if a business sold for $2 million and generated $500,000 in normalized EBITDA, the implied EBITDA multiple would be 4.0.
By analyzing multiple transactions, the appraiser can develop a range of multiples that may apply to the business being appraised.
However, comparable transactions are rarely identical. Differences in company size, profitability, growth, management, customer relationships, and operating risks must be considered.
The appraiser must also determine whether the transaction prices and financial measures are comparable. Differences in debt, working capital, included assets, and transaction structure can materially affect the multiples.
The objective is not simply to calculate an industry average, but to select a multiple that is appropriate for the specific business being valued.
Several factors can influence the multiple that a buyer may be willing to pay for a business.
Profitability and financial stability: Businesses with consistent earnings and reliable cash flow may command higher multiples than businesses with volatile or declining performance.
Growth prospects: Companies with demonstrated growth and reasonable expectations of continued expansion may attract higher multiples.
Customer concentration: A business that relies heavily on one or two major customers may carry greater risk than one with a diversified customer base.
Owner dependence: A business that cannot operate effectively without its current owner may be less attractive to prospective buyers.
Management and employees: An experienced management team and stable workforce can reduce operating risk and improve the transferability of the business.
Industry and market conditions: Buyer demand, competition, economic conditions, and industry-specific risks can all affect transaction multiples.
Capital requirements: Businesses requiring substantial ongoing investment in equipment, facilities, or working capital may be valued differently from businesses with similar earnings but lower capital requirements.
These factors help explain why two businesses with similar financial results may have substantially different values.
EBITDA and Seller's Discretionary Earnings are two commonly used measures of business earnings, but they are not interchangeable.
EBITDA is generally used when analyzing larger businesses or companies with established management structures. It measures earnings before interest, taxes, depreciation, and amortization, while generally retaining management compensation as an operating expense.
SDE is more commonly used for smaller, owner-operated businesses. It generally includes EBITDA plus the compensation and benefits of one owner-operator, along with appropriate normalization adjustments.
Because SDE generally includes an owner's compensation, it is often higher than EBITDA for the same business. Consequently, an SDE multiple will generally be lower than an EBITDA multiple when both are calculated from the same underlying value.
For example, a business generating $200,000 in EBITDA and $300,000 in SDE might have an indicated value of $900,000 under either of the following calculations:
These are illustrative multiples, not recommended benchmarks.
The important point is that the earnings measure and valuation multiple must be consistent. Applying an EBITDA multiple to SDE, or vice versa, can produce a misleading result.
Yes. Even businesses operating in the same industry and generating similar earnings can have significantly different valuation multiples.
Consider two manufacturing companies, each generating $500,000 in annual EBITDA.
The first company has a diversified customer base, experienced management, modern equipment, and stable earnings.
The second relies on one major customer, depends heavily on its owner, operates older equipment, and has experienced declining revenue.
Although both companies report the same EBITDA, a buyer would likely view their risks and future earnings prospects differently.
The first company may support a higher valuation multiple because its earnings are more predictable and the business may be easier to transfer to a new owner.
This is why applying a generic industry multiple without considering the characteristics of the business can produce an unreliable estimate of value.
Industry average multiples can provide useful context, but they should not automatically be applied to every company within an industry.
Published multiples may reflect transactions involving businesses of very different sizes, financial characteristics, and operating structures.
In addition, some transaction databases contain limited information about the businesses sold, making it difficult to determine whether the reported multiples are directly comparable.
A professional business valuation considers the available market evidence and the specific characteristics of the subject company before selecting an appropriate multiple.
Business valuation multiples are useful tools, but they are not universal formulas.
A supportable multiple should reflect relevant market evidence, the financial performance of the business, and the risks and opportunities associated with its future earnings.
The earnings measure used in the calculation is equally important. Even a well-supported multiple can produce an unreliable value if it is applied to earnings that have not been properly analyzed or normalized.
Understanding these factors can help business owners better evaluate estimates of value and recognize why similar businesses may sell for different prices.
There is no single multiple that applies to all small businesses. Multiples vary by industry, company size, profitability, growth, risk, and the earnings measure being used. A multiple appropriate for one business may not be appropriate for another.
Possibly, but three times earnings is only a rule of thumb unless supported by relevant market evidence and analysis. The appropriate multiple depends on the business, the definition of earnings, and the circumstances of the valuation.
Both revenue and earnings multiples are used in business valuation. However, earnings multiples are often more informative because they account for profitability. Revenue multiples may be useful in certain industries or circumstances, but businesses with similar revenue can have very different earnings and values.
Larger businesses may benefit from more diversified customers, established management, better access to financing, and lower dependence on individual owners. These characteristics can reduce perceived risk and support higher multiples. However, company size alone does not determine value.
Not necessarily. The total indicated value depends on both the multiple and the earnings to which it is applied. A business with a lower multiple but substantially higher earnings may have a greater overall value than one with a higher multiple.