Choosing industry specific valuation multiples is one of the biggest challenges in business valuation. When done right, such “apples to apples” comparison offers you a very defensible way to demonstrate what a business is worth.
Typical valuation multiples
You can calculate the estimate of business market value using a number of valuation multiples – each establishing business value in relation to some measure of its financial performance. Here is our short list of the valuation multiples most commonly used to value private businesses:
- Enterprise value (EV) to gross revenues or net sales.
- EV to net income.
- EV to EBIT and EBITDA.
- EV to seller’s discretionary cash flow (SDCF or SDE).
- EV to total business assets.
- EV to owners’ equity.
Do valuation multiples vary by industry?
A key question: just how much do the valuation multiples vary by industry sector? Let’s take a closer look at what such valuation multiples represent.
Business value is about risk and returns. Hence, to measure what a company is worth, you need to estimate both its earning ability and assess its risk. The standard way to evaluate business risk is to calculate the so-called discount and capitalization rates. There are a number of well-known income-based valuation methods that you can then use to appraise a business.
Market valuation multiples are related to this concept. This is especially clear when these multiples are applied to business earnings such as EBITDA or net income. In fact, these valuation multiples act pretty much as the inverse of the company’s capitalization rate – instead of dividing the business earnings by the cap rate, you multiply it by the valuation multiple. The result is the estimate of what your business is worth.
Industry risk premium and valuation multiples
If you take a close look at the Build-Up cost of capital model used to calculate the discount and cap rates for your business, you will see that one key component is the industry risk premium. This additional part of business risk depends, as the name implies, on the industry sector the company competes in.
Businesses in high risk industries are less valuable
The higher the industry risk premium, the lower the valuation multiple. This means that, for a given earnings forecast, the business value is lower. Put another way, the businesses in an industry with a high risk premium are more risky and, therefore, worth less.
How to choose the best valuation multiple
With all these valuation multiples lying around, the question is: which one is the best? The best multiple is, of course, the one that lets you predict the business market value most accurately.
Let’s go back a step here. Remember that all valuation multiples are derived statistically from past business sales in your industry sector. So you have a set of business sales, each with its own set of financials and the actual business sale price.
Armed with that data, you can calculate all kinds of valuation multiples and use them in estimating your business value. But statistics tell us an interesting story: different valuation multiples exhibit different spreads.
So it could happen that in your industry sector one valuation multiple, e.g. the one based on EBITDA, shows a ‘skinny’ bell curve with business values clustering tightly around the average. In contrast, the business value to gross revenue multiple could generate value estimates all over the map.
What does it mean? Market participants in your industry tend to rely more heavily on one multiple when pricing the business sale deals. One typical example is pricing professional practices based on gross revenues since practice owners have considerable discretion in what they recognize as EBITDA or Net Income.
Business appraisers use a secret weapon to estimate the spread of valuation multiples. It is called the coefficient of variation and it equals the ratio of the multiple’s standard deviation divided by the average. For a given multiple, the smaller the coefficient of variation, the tighter the spread of business values, and the more accurate your estimate.
So here is a suggestion on selecting the best valuation multiple:
- Gather enough data on recent business sales in your industry.
- Calculate a number of valuation multiples from this data using the actual business sale prices related to the companies’ financials.
- Calculate the coefficient of variation for each multiple.
- Choose the multiple with the smallest coefficient of variation.
Valuation multiples by industry – some examples
Just how much do valuation multiples vary by industry? We’ll use the typical Business value to EBITDA multiples for several industry sectors to demonstrate the difference:
|Industry Sector||SIC Code||EBITDA Multiple|
|CPA / accounting practice||8721||4.38|
|Construction defect restoration||1522||4.62|
|Custom software development||7371||7.61|
|Engineering consulting firm||8711||8.19|
|Family medical practice||8011||2.71|
|Gas station with C-store||5541||2.27|
|Heavy construction services||1611||4.37|
|Plastic products manufacturing||3089||6.16|
|Restaurant and sports bar||5812||2.22|