How To Select An EBITDA Multiple
Updated: May 23, 2019
It's the magic number that business valuers seem to pull out of their....back pocket. The EBITDA multiple is part of the most common method used in business valuations, and one of the most simplest formula for calculating the value of a business.
EBITDA Multiple Formula
To arrive at an enterprise value (EV), if this method is appropriate:
EV = EBITDA Multiple * Adjusted Ongoing EBITDA
In essence the EBITDA Multiple is a measure of the risk of the business - the higher the risk the lower the multiple.
It has an inverse relationship with cost of capital - the higher the risk the higher the cost of capital. We will be exploring the cost of capital concept in future months, especially in relation to privately held SMEs. But for now think of EBITDA multiples as a measure of how many years cash flow you are prepared to pay to accept the risk of the business.
So how do we work out EBITDA Multiples?
Contrary to popular opinion it is not just 3.0x plus or minus 5%. And there is an evidence based process that we use. Most business valuers use a similar process, and it is like a two stage "zoom in":
Using industry benchmarks or similar transactions to identify a broad range - eg between 1.6x - 3.5x
Assess the business against key risk or performance criteria to "narrow" the range.
Stage 1 - Selection of a broad EBITDA Multiple Range
It is important to that the EBITDA Multiple range selected in Stage 1 is not too broad, otherwise the assessment in Stage 2 can have a significant impact on the business valuation. The questions we ask in arriving at our broad EBITDA Multiple range include:
For a business in this industry and of this size, what is the lowest and highest EBITDA multiple observed in other transactions?
Are the low and high EBITDA Multiples observed likely to represent transactions that deviate from the definition of market value?
Is the high EBITDA Multiple more likely to result from a transaction where the standard of value is more representative of strategic value rather than market value?
Is the low EBITDA Multiple more associated with a business or business owner under financial stress or a transaction not at arms length?
In selecting these low and high EBITDA Multiples we make sure we consider the size and scale, profitability and growth factors and key industry trends of our comparison businesses compared to the target business being valued.
Sometimes we can use industry benchmarks to help guide the selection of EBITDA multiples in this stage, or published evidence of similar transactions. Exit Value Advisers maintains its own proprietary databases of privately held business transactions and regularly report the results in our Valuation Affairs newsletters. In these newsletters we also update the EBITDA Multiples of selected listed ASX stocks to use in assessing upper limits for some businesses.
Stage 2 - Narrow the EBITDA Multiples Range
The assessment in Stage 2 will typically consider a range of twenty different factors (which we discuss below), but they are broadly grouped around such risk factors as:
Historic Financial Performance
Ongoing risk to revenue
Key person risk
Developed and documented systems and processes
Technological and industry risk
Depending on the business we will also adjust the multiple by other factors that may be industry specific.
We use this assessment to determine if EBITDA multiples applied to the business should be at the low, median or high end of the broad range we have identified. The narrower the broad range, the more likely our business valuation process will "hit the mark". It will ultimately depend on the data that you can collect.
Cross-checking the EBITDA Multiples
As we mentioned earlier we collate a wide range of data from different sources into a proprietary database that guides our EBITDA Multiples selection process.
However there is another cross check that can be applied to this process. We sometimes use EV:EBITDA Multiples from ASX data to derive an upper boundary for businesses that operate within the same industry. The multiples of listed companies are higher than the corresponding EBITDA multiples for SMEs. However we can get a guide as to what the SME multiples should be using a discounting process.
An example of such a calculation is shown below where we have discounted the EV:EBITDA multiple of JB HiFi post their recent 1H19 results announcement.
Using these discount factors we can infer that SME retailers in a similar space to JB HiFi (sale of discretionary household goods) could expect an upper bound on their EBITDA multiple of 4.2x. This would typically be reserved for a retailer with multiple outlets and revenue in excess of $10m.
A smaller single-outlet retailer is more likely to attract an EBITDA multiples in the 2.0x - 3.0x range.
We do not imply that a small business with revenue less than $2m is comparable to a listed company. But we do use data from listed companies in similar industries to inform us on what an upper limit should be for larger SMEs in the same sector.
In essence it provides a broad cross-check on the original valuation.
What are the factors that we consider in narrowing the EBITDA Multiple Range?
We look at the following factors and assess whether the factor is likely to shift the EBITDA Multiple of the business being valued above or below the median of the EBITDA Multiple range selected.
The core factors we consider are:
Nature of the revenue or customer base
Level of recurring revenue, repeat customers, certainty of future revenue
Likelihood of past revenue trends influencing future revenue levels
Effectiveness of marketing strategies
Past profit performance against industry benchmarks or expectations
Expected cost savings in next 12 months
Expected profit trends in future
Cash reserves and cash management processes
Reliance on key staff/owners
Extent of IT system integration
Extent of automation and use of technology
Extent of documentation and communication of procedures and processes
Extent of competitive advantage
Condition of assets/resources
Effective and proven strategies and actions in place to generate future profits
Regulatory, legal or other issues
Lifecycle of business compared to industry
Impact of economic fluctuations and changes
Level of competitive pressures
Depending on the nature and complexity o the business we may also include other factors in our assessment. One of the benefits of such an extensive assessment process is that it minimises the effects that one factor can have over the EBITDA Multiple range selected.
However, we must also use our experience in identifying factors that may have a significant short term impact on EBITDA Multiples. A recent example of this is the regulatory uncertainty in the insurance and mortgage broking industry post the Haynes Royal Commission. In the current climate, this factor would be expected to have a significant impact on EBITDA Multiples.
What is your EBITDA Multiple?
How would your business rate? What is the industry valuation multiple range for your business? We have made a comprehensive list of the industries we have completed business valuations and detailed the issues and typical industry valuation multiple expected for different size businesses. Find your industry in the list and see what issues impact the EBITDA multiple for your business.
What would an improved multiple mean for the value of your business?