One of the easiest and most defensible ways to approach valuation of a private company is to compare against the recent sales of similar businesses.
These multiples are ratios that relate the company’s financial performance to its potential selling price and, therefore, its fair market value.
One valuation multiple that is used often is the business price to its gross revenues. Others include value measures based on the company’s net profits, gross margin, EBITDA, cash flow, assets, and value of business owners equity.
Given the wide choice of valuation multiples, when does the price to gross revenues ratio work best to value a private company? Here are the typical situations:
High growth company valuation
A company that is focused on revenue growth may not yet be optimized for profitability. Hence, its value lies in its ability to generate sales. Valuing such a company on its gross revenues is a good choice.
Technology based company valuation
A special case of high growth businesses, the technology companies invest heavily in intellectual property development and marketing. It is not unusual to see negative returns for quite some time – even for companies with a commanding market share.
If you want to develop an estimate of market value for a technology company using business sales comparables, the gross revenue tends to be a more accurate basis than current profits or cash flows.
Professional practice valuation
Medical and dental practice valuations often rely on the practice sales as the preferred basis. One reason is that established practices tend to show similar profitability given the level of revenues.
Another key reason is that the value of a professional practice is most directly related to its ability to attract and retain clients. Gross revenues from client billings thus offer an excellent basis for estimating what a practice is worth.
Valuation multiples change over time – some surprises
We study the private business sales data all the time and run into quite a few surprises when selecting the best valuation multiples for our clients.
As market conditions change in an industry, business people tend to change their attitude to what drives business value.
A large group of business investors known as financial buyers tend to value companies based on their profitability. They are less likely to be impressed by business revenues, unless their expectations of returns and risk are satisfied. Financial buyers tend to use valuation multiples that are based on business cash flow, EBIT, EBITDA, and net income rather than revenues.
One example is the food and drink industry. Our analysis of restaurant sales in recent years shows that business buyers have relied on the price to discretionary cash flow valuation multiples when pricing acquisition deals.
This is a shift from an earlier trend when most deals were priced using the gross revenue based valuation multiples.
Business valuation using several multiples
Recent sales of private businesses are an excellent source for estimating your business value. See how to determine the business value based on its gross revenues, net sales, profits, cash flow and assets.
To get an accurate business valuation you should not limit yourself to using just a single valuation multiple. In fact, you can appraise any business three ways:
- Based on the business income generating capacity.
- Based on the company’s asset base.
- By comparison to sales of similar firms.
Look at a professionally prepared business appraisal report and you will see that several methods are used to calculate what the business is worth.