Archive for January, 2011

When it comes to valuing a private business using market-based methods, one valuation multiple that stands out is the price to business revenues. Actually, there are two variants of this distinguished valuation tool:

  • Price to gross revenue
  • Price to net sales

In fact, there are a number of industry sectors where the price to sales valuation multiples are preferred. Here are the top ones:

  • Professional practices, especially medical and dental practices
  • Technology companies in high growth mode
  • Manufacturing businesses, especially those in emerging market segments

With so many valuation multiples to choose from, why would business people and professional appraisers trust price to sales numbers more? Because in some situations this measure of business value is more reliable. Here are some scenarios when you may want to consider using the business revenues as the key basis to appraise a company:

Professional practice value is about client retention

Client retention is essential to preserve the value of a professional practice that is being sold. Essentially, the practice buyer is after the revenue stream of the practice and may have plans regarding profitability improvement or capital investments. Hence, the valuation multiples based on profits, say the practice net income or EBITDA, as less valuable when estimating what the practice is worth.

High growth company value depends on sales growth

Young growing companies can become very attractive if they manage to establish themselves as a leader in a market niche. Their ability to generate revenues in a highly promising industry sector is the major value driver. In this sense, the company’s revenue is a strong predictor of its success – that sheds light on how valuable the firm is.

At the same time, such companies may not yet have been optimized for top profitability. In addition, further business expansion may call for considerable capital investment. So, again, using valuation multiples based on profitability or current asset base is not as revealing.

Business value is driven by market share and revenue growth

The same argument holds for established manufacturing businesses that are successful in a new market sector. Imagine a company that has developed a strong customer following in one of the green industry segments.

Early entrants with a compelling product and service mix tend to grab market share and generate sales quickly. You can capture this key value driver by using the price to revenue valuation multiples when appraising such a company.

Income valuation methods to supplement your business appraisal

To round out your business valuation, do not forget to take advantage of other methods, especially those under the income approach. The Discounted Cash Flow method in particular is an excellent supplement to value a business based on earnings forecast and risk going forward.

Such expectation driven business appraisal is a powerful way to verify the business value estimates you get from the market-based valuation multiples.

Business Valuation using all Three Approaches

Application software companies are a large industry sector, classified under SIC code 7372 and NAICS 511210, and composed of firms engaged in the development, production and marketing of specialized software products.

In this day and age virtually all industries rely on some form of business software to power their operations. As a result the application software sector continues to grow. As of 2011, some 8,200 US players have chalked up a grand total of over $135B in annual revenues. The industry employs some 386,900 with an average of 47 staff per firm.

While the application software industry is well know for its multi-billion dollar industry titans, most software firms are small to mid-size businesses. In fact, the average application software development company generates close to $16.3M in annual revenues. About 92% of the companies employ less than 25 people and contribute $19.8B in annual sales to the sector’s total.

Business valuation of application software firms

Given the growth rates often achieved by software firms along with their profitability potential, emerging companies are frequent acquisition targets. Market-based valuation methods are quite common when valuing businesses in this industry.

Valuation multiples relating the enterprise values of comparable firms to their financial performance are the typical tools to appraise a business in this industry. The most common valuation multiples used are these:

  • Enterprise value (EV) to revenues (net sales)
  • EV to EBITDA
  • EV to Property, Plant and Equipment (PPE) assets
  • EV to total business assets
  • EV to book value of owners’ equity

Example: Using valuation multiples to value an application software company

To demonstrate the application of multiples, we pick a sample software company with the following annual financials:

  • Revenue: $10,000,000
  • EBITDA: $1,800,000
  • Total business assets: $14,300,000

Applying the valuation multiples to each financial measure basis, we calculate the business value as shown in the table below:

Multiple Multiple value Business value
EV to net sales 0.7171 $7,170,626
EV to EBITDA 4.1042 $7,387,570
EV to total assets 0.6097 $8,719,222
Average Business Value $7,759,139

In this example the business value estimates across all valuation multiples fall pretty close together. The spread of valuation results can be considerably greater depending on how well the subject business performs against a specific financial measure compared to industry peers.

Multiples for valuation in your industry