?Jack Mordes

Principalbgv group

2007 business and goodwill valuation group pty ltd

V A L U E A T O Rby bgv group

valuation group pty ltdbusiness & goodwill

valuationmultiples

reallymean?

what do

Valuation methodsThere are many approaches to valuing a business including:

Although a discounted cash flow (DCF) is consid-ered the most theoretically correct valuation meth-odology, a multiple-based or capitalisation of earn-ings valuation is the most commonly used.

This is largely due to its simplicity, particularly relative to the DCF method.

Capitalisation of earnings or multiple-based valuation;

Discounted cash flow (or DCF) model;

Asset-based approach; or

A rule of thumb valuation such as a per bed valuation for a hospital.

Elements of a multiple-based valuationA multiple-based valuation involves two distinct but interrelated steps:

For example, if a valuer determines a multiple of 4x to apply to a business with maintainable earnings of $500,000, the value of that business will be $2,000,000 (4 x $500,000).

First, a valuer must estimate the future maintainable earnings of a business; and

Second, multiply (sometimes also called capitalise) those earnings by an appropriate capitalisation or earnings multiple.

Determining maintainable earningsDetermining a businesss maintainable earnings is not as straightforward as looking at the last few years accounts. Often, adjustments need to be made for:

However, the subject of determination of maintain-able earnings is worthy of a separate article itself and here we will only focus on the discussion of multiples.

owners salary and other discretionary expenses;

one-off or non-recurring expenses or earnings;the impact of business cycles; and

future growth prospects.

2007 business and goodwill valuation group pty ltd

VA L U EA T O Rby bgv group

Multiples: what do they mean?

If we were to buy ABC for $5,000,000, our return on that investment would be the earnings we could gen-erate from it. On a pre-tax basis, this would be $1,000,000. So, our return would be earnings amount invested. In ABCs case this is $1,000,000 $5,000,000 = 20% = 1/5.

Accordingly, the inverse of the valuation multiple tells us the return on investment (ROI) that the asset is likely to generate. A business purchased on a 4x valuation multiple will generate a 25% return on investment, a business purchased on 5x will gener-ate a 20% return on investment and so on. This is set out in the table below.

The return on investment implied from a given valua-tion should be compared to the returns available on other asset classes in order to determine whether the investment offers just reward for the inherent risks. For instance, the return on an investment in ABC should be compared to the returns available from other asset classes such as the:

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Australian share market (last 4 years return has averaged ~25% and the long term average is ~12%);Residential property average returns of ~10-15%;

International shares of ~10%;

Private equity investments of ~15-25%;

Bonds of ~6-7%

It is important to remember that a high valuation multiple implies a low return on investment.

Factors influencing the choice of a multipleSelecting the appropriate multiple with which to value a business depends on many factors including:

size of the business: the larger the business, the higher the multiple;

growth prospects: a business with good prospects for future growth will generally attract a higher valuation multiple than a more mature business with limited growth potential;

the businesss risks: for example, key-man risk, industry and competitive risks or foreign exchange risk;

size of ownership interest: in general, the valuation of a controlling interest of a business (i.e.>50%) will attract a higher multiple than that which applies to the valuation of a non-controlling stake;

capital intensity: if a business can grow without the need for more capital, then it will attract a higher multiple;

which earnings are used: the selection of multiple will depend on which earn-ings measure is being used: (i) earnings before inter-est, depreciation and amortisation (EBITDA), (ii) earnings before interest and tax (EBIT), (iii) net profit before tax (NPBT), or (iv) net profit after tax (NPAT).

A multiple also tells us about the returns likely to be generated from the business.

Take the example of ABC, a business that makes $1,000,000 in earnings before interest and tax (EBIT) and is being offered for sale for $5,000,000. The multiple implied by its sale price is 5x (price EBIT or $5,000,000 $1,000,000 = 5). But what does this number mean?

2 4 6

50% 25% 17%

8 10

13% 10%multiple

1= ROI

multiple (x)

2007 business and goodwill valuation group pty ltd

V A L U E A T O Rby bgv group

Multiple ranges

Preparing even a rough guide as to valuation multiples is fraught with potential pitfalls. However, as a general guide, we offer the following insights.

Very small businesses are valued at low multiples (2-3x) reflecting their size, risk and liquidity of owner-ship interest. Medium sized businesses are valued at higher multiples of 4-7x depending on their size and risk profile. Very large businesses are valued at multiples of >8x and it is not uncommon for transac-tions among public companies of well above 10x reflecting synergy potential and low cost of capital.

The table below outlines the general range of multiples of businesses of varying sizes and charac-teristics.

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The table above should not be used other than for mere informational purposes, as it is possible even for very small businesses to be valued at a high multiple if for example those businesses have high strategic value to a particular acquirer or have devel-oped an asset of high potential value that as yet gen-erates a small (or no) income. Expert advice should be sought.

multiple range 2-3x 4-5x 6-7x >8x

implied return 33-50% 20-25% 14-17%