Scale Increases Valuations
Scale can be a key factor in valuations - especially when an owner is wanting to attract a buyer willing to pay a premium.
We have mentioned in previous posts that growth can be included in ongoing earnings (Growth and Valuations), but scale and growth also influences the EBITDA multiple used in valuations. The more scale that can be realised the greater the influence on the multiple.
In a recent press release Michael Sonego, a partner at Pitcher Partners, said “...as companies try to protect if not enhance the size and scale of their business reach, ...it sets the scene for a further surge in mid-market M&A activity this year...”.
Sonego goes on to explain that it is expected that M&A will fuel strategic growth in the next 12 months as a result of "...low organic growth conditions, all-time low interest rates and ever-changing technology would be key drivers for mid-market M&A [$10m - to $250m in valuation] in Australia in 2018."
We typically see increases in multiples of at least 20% - 30% as a company goes from a small scale (revenue less than $2m pa) to a larger size (annual revenue greater than $5m - $10m). The ASX reinforces this with typical enterprise value:EBITDA multiples for most non-resource stocks in the range 8x - 14x EBITDA. The larger the business the more attractive it is and the higher the EBITDA multiple it attracts.
But one of the key attractions for scale from a buyer is the potential to apply their business across that scale. It means they get so much more than just a combined business - they can reach even larger market share, have a greater influence on the market and sidestep their competitors. Scale creates more opportunity than just 1 + 1.
The current conditions of low inflation and low growth in GDP will make it difficult for many SMEs to sustain growth. Our own experience with clients have seen revenue growth expectations over the next 12 months to range from depressed to sporadic. So gaining scale is going to be difficult unless it is done through a strategic growth program.
In the current climate being able to reach a wider market will be more about putting in place the "infrastructure" needed to sustain scale. This means:
Development of new channels to reach new markets.
Product and service development that will deliver long term growth.
Ability to deliver increased volume of products or services at the expected quality.
Systems and procedures to manage an increased volume.
Sales resources to reach and manage a wider market size.
So when assessing a company to determine the appropriate EBITDA multiple, we consider not only the current market share and size but also the capacity to support an increase in market size and meet delivery and quality expectations.
We can also consider scale in terms of the overall size of the relevant market. For example a speciality food products manufacturer with revenue of $2m may have negligible scale in a wider generalised $2.5b market. But they become more significant when looking at niche markets that are only $25m - $40m in size. The questions then become can their marketing message and capacity to deliver play a larger role in the niche market and will this result in increased returns? If yes, then it will be a more attractive investment and is likely to attract an increased multiple.
We often review small regional businesses, and whilst they may have no scale past their existing region, the impact they have within the region becomes important. A small engineering firm in regional Victoria may not be able to compete with larger operators, but they may have a closer relationship with local clients and are able to secure market share that a city-based operator cannot service directly. This is unlikely to increase the multiple from a 2x EBITDA to something more than 3x, but it will support a higher result.
Exit Value Advisers uses a two-stage process for zeroing in on a multiple range. We first look for a very broad range (such as 2x - 4x EBITDA) that can be supported by evidence. Then we assess the business on a range of attributes to see whether the multiple is likely to be above the range midpoint or below.
These attributes includes the extent of market share, past growth results and the ability to deliver future growth, the maturity of the market and the strategies being deployed to seek new markets.
Our latest Whitepaper (Valuation 101 - What You Should Know About Valuation) explains the theory of valuation, why you need a valuation and the process of doing a valuation. Download a copy and feel free to contact us for an obligation-free confidential discuss.
If you want to know the value of your business and how growth will impact its potential value then give us a call and discuss our business valuation process and the benefits it will deliver.