When you're reviewing a business's overall financial health, one term that is often tossed around is valuation multiples. If you are unfamiliar with this variable measurement, it can seem like a complex concept, therefore, we will attempt to break it down in a more simplistic way. Here's a brief overview of what valuation multiples are, how they're calculated and how they can impact a company's overall value.
What are valuation multiples?
A valuation multiple represents a figure that is applied to a company’s overall income or revenue based on the industry and market they are in, as well as a projection of the reasonableness of long-term earnings. The estimated figure by which the income is “multiplied” is deemed the valuation multiple. Depending on the business involved, this multiple can be anywhere from a 1x to 50x multiple on a broad scale basis.
How is the valuation multiple estimated?
Multiples represent a certain expected amount of income per year. If a company is measured at a multiple of 3x, it means that a buyer is willing to pay the equivalent of three times the expected annual income to the seller. At this multiple, the company's income is estimated to pay back the investor over the course of three years, assuming it continues to perform as expected based on historical practice. A multiple of 5x means the company is valued at five times the projected annual income and that a buyer will see the investment returned over a five-year period. However, if a company is actively growing, much higher multiples may be utilized, based in part on the reasonableness that the business has a long-term ability to continue to generate steady or growing revenue.
How do valuation multiples help measure your company's worth?
What impact can these valuation multiples have on your specific company's financial health? To use an example, a startup tech company may have revenue of $50,000 in its first full year of operation with an increase to $200,000 in the second year. If it's purchased at this point, where should the multiple fall? If it's projected to quickly grow to $5-10 million in revenue annually, say within five years, paying a multiple in the range of 20x-40x annually may be considered acceptable. This is not atypical for startups with rapid growth potential.
More commonly, however, in businesses with historic, longer-term steady levels of revenue in the small to a mid-size market sector, you will see valuation multiples between 1x-10x based on a number of factors, including diversification, contractual relationships, competition, intellectual property (ex: patents, domain names, trademarks), and the industry or market involved.
In summary, if you are interested in understanding the valuation multiples of a particular business, you should engage a certified business valuation professional who utilizes standardized methodologies to measure this variable as part of a larger appraisal effort. By understanding how valuation multiples are calculated, you're in a better position to improve those numbers and pay or receive a fair price for your company, whether it's for a business loan, company sale, or purchase.
Knowing the current value of your business can provide you with ideas to improve areas that may need help, while further capitalizing on areas of strength, to continue to operate a successful company. By working with a certified business appraiser, you are ensuring that the valuation multiples and other factors you work with are current and accurate in relation to your company's overall value.