Growth and Valuations
Updated: May 16, 2019
In a previous post I mentioned the P's and Q's of valuation (https://www.exitvalue.com.au/blog/what-are-ebitda-adjustments) and that growth should be factored into the ongoing earnings of a valuation. I also pointed out some criteria when growth should be included:
Demonstrated history of revenue increases that match the strategy of the business.
Price increases that match market and industry expectations.
Implementation of strategy that is inline with past experience.
When a potential buyer is examining a business for acquisition and sees growth included in the valuation it often becomes a point of negotiation. They will often shout loudly - "I won't pay for growth - there is too much risk. I will base my valuation on last years' EBITDA plus adjustments". And invariably this is as much about negotiation tactics and bluster as it is about theory.
Growth (in revenue and EBITDA) is an integral factor in valuations as it is often the driving force for the acquisition. Growth in EBITDA should be factored in where the vendor can demonstrate:
History of past growth.
Systems in place to support ongoing growth.
Reduced reliance on key owners or staff.
External market and industry trends that support ongoing growth.
The difficulty becomes to what extent should earnings be increased to account for the expected growth? The answer depends on the valuation method and the confidence in the results.
If a DCF (Discounted Cash Flow) method of valuation is being used then I typically incorporate a conservative percentage increase in the first 2-3 years of the explicit projection period and then set the growth to nil or perhaps some nominal CPI level.
But when using the FME method (Future Maintainable Earnings) then I may base the ongoing earnings on the previous year result plus the CAGR of the past 2-3 years. Where ongoing earnings has been significantly adjusted from previous years due to a change in the cost model of the business, then I am more likely to be very conservative in including growth rather than bullish, to prevent over-estimating earnings.
I recently valued two companies where revenue had grown by 20-30% per year for the past 3-4 years, and showed evidence of continuing. However one business was exposed to the residential building sector whilst another business was dependent on the food manufacturing sector. I was more conservative with allowance for growth in the business exposed to the building sector due to the level of uncertainty associated with local factors. I included 10% growth in ongoing revenue instead of 25% or 30% based on previous years.
Another key factor to consider is whether revenue growth translates to EBITDA growth - which after all is what all owners and valuers are really concerned about. In some cases I have seen revenue grow consistently but it doesn't result in an increase in EBITDA at all. This is usually a negative factor in valuations as it raises questions about the profitability and viability of the business.
It is also common to see businesses that have a sudden increase in EBITDA. In some cases this is tied up with revenue growth past a break-even point, especially when a business has very low variable costs and a high break-even point. In other cases it relates to a change in business conditions or the cost model and signals an ongoing improvement to EBITDA.
Growth in revenue and EBITDA also impacts the enterprise value multiple - but that is another BLOG post. The key is to consider growth carefully in business valuations to make sure the answer is right and to avoid over-valuations.
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