If you need to get an objective estimate of business value, consider using the valuation multiples derived from the recent sales of similar businesses. There are a number of advantages:
- Business valuation with multiples is easy to understand and explain.
- In times of economic uncertainty, business people and professional appraisers carefully consider the market trends when valuing a business. Market value estimates using the valuation multiples are an excellent way to do so.
- If the business is to be bought or sold, market comparisons are a must to defend your asking or offer price.
- Market comps are also a great way to prove your point if your business valuation is challenged.
Types of valuation multiples
Business appraisal experts and seasoned investors use quite a number of valuation multiples depending on the specific business or the reasons for business valuation. Here are the most common choices:
- Valuation multiples based on business gross revenue or net sales.
- Gross and net profit-based valuation multiples.
- Earnings based multiplies relating the business value to its EBIT, EBITDA, or discretionary cash flow.
- Valuation multiples based on business assets and owners’ equity.
Reasons for choosing the earnings-based valuation multiples
Business valuation is about earnings and risk. For small owner-operator managed companies, the discretionary cash flow based multiples are the usual choice. For larger small and mid-market businesses the typical basis is EBITDA. There are a couple of reasons why the EBITDA based valuation multiple is often preferred:
- Business owners have control over the company’s capital structure. Hence, the interest expense is viewed as discretionary and added back to calculate the available cash flow.
- Many private firms are structured as pass-through entities for tax purposes, such as S-Corporations or LLC companies in the US. Since these companies do not pay tax directly, adding back the taxes makes sense.
- Depreciation and amortization are paper expenses and do not affect the business cash flow. They are added back to calculate EBITDA.
To sum up, EBITDA is a good way to represent the available business cash flow to calculate the value of private companies. The EBITDA-based valuation multiples are a common choice in valuing larger businesses in these industries:
- Manufacturing firms
- Technology companies
- Professional services businesses
Current EBITDA valuation multiples for major industries – some examples
As the market conditions change, so does the value of your business. Valuation multiples based on recent business sales help you track changes in your company’s market value. Here are some typical EBITDA valuation multiples by industry:
|Metal products manufacturers
|Engineering and architectural services
|Prepackaged software companies
The EBITDA multiple for software companies may seem high. However, these firms tend to show considerable variation in earnings. It is a good idea to check your results using other valuation multiples. For example, these firms tend to price at about 2.5 times the net sales.