Sunday, August 17, 2014

Business Valuation Multiples

Earnings multiples and so called rules of thumb have been around as long or longer than the practice of business valuation itself.  One of the key approaches to estimating the value of a business is the Income Approach, which is based on the present value of future expected earnings.  That sounds very similar to a multiple of earnings, doesn't it?  It may, but it isn't.

Using a multiple of earnings may not be a bad way to put the value of a business into a very large ball park, but that's where the thumb ruler should stop. Promising to buy any company for four times earnings - because you heard that was the going rate - makes as much sense as promising to buy any real estate for $100,000 per acre for the same reason.  Yes, every piece of real estate is unique, and so is every company.  Therefore, your source of earnings is also unique.  Paying a set amount for a every company's earnings means the investor is requiring the same rate of return on each company.

Paying a set multiple for earnings fails to account for growing earnings, declining earnings, volatility of earnings, the risk or lack of risk attached to the specific business and its earnings, and last but not least the degree to which the assets being acquired can be collateralized.  All of these things can dramatically change the rate of return realized to an investor on companies with the same earnings at the start.

Which earnings?  EBITDA is the usual favorite to which multiples are applied.  But EBITDA can also be deceiving, particularly in a business that is capital intensive, because it fails to account for the reduction in cash flows resulting from necessary reinvestment into equipment.  

When it's time to make or accept an offer, a difference of 4, 5, or 6 times earnings can mean millions.  A thorough valuation of the company can expose its real drivers of value.  That's a small investment that can save a buyer or seller from making a million dollar mistake!

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.


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