Factor growth into your EBIT multiple
Monday, September 3, 2007/
Where standard metrics are relied upon to evaluate your business for sale, any boost is worth pursuing. By TOM McKASKILL.
By Tom McKaskill
Most industries have a valuation norm expressed as an earnings before interest and tax (EBIT) multiple. While some specialised niche sectors might replace this with a value per account or multiple of revenue, these are only surrogates for the conventional EBIT method.
Most experienced business owners who are sensitive to business sales within their sector will normally be able to tell you what the valuation norm is within their own industry, but few can explain why a specific multiple is used.
When I have asked groups of entrepreneurs to explain why their sector has a specific multiple, they will normally cite industry risks, product life cycles, economic conditions and industry volatility.
Basically they don’t know why and can only guess. Much like getting a valuation on a house, the business advisers look to comparables within the sector to establish the norm.
However, when I ask them to state how they would move the multiple up, say, from four to six times EBIT, most of them will say that they need to grow faster. But how much faster? Generally they don’t have any feeling for the impact of low or high growth on the multiple – just that it will help.
An EBIT multiple is really a reflection of an underlying net present value calculation where future net earnings are discounted by a discount rate to gain a value for the initial investment. Thus a four times EBIT is a close approximation for a 25% discount rate. If you use the net present value (NPV) method to derive your valuation, the impact of growth can be calculated with some accuracy.
By simulating a 10% cumulative growth (year-on-year growth of 10% in net earnings) you can show that the valuation will double. If you try a 20% cumulative growth rate, the valuation will increase by a factor of five.
Growth has a huge impact on valuation, but is normally under-represented in conventional valuation processes because buyers, sellers and business brokers are unsophisticated when it comes to valuation theory.
Of course, even if you understand how to do these calculations, you may have difficulty convincing both your adviser and your buyer. If you are able to demonstrate significant growth, you need to work with a more sophisticated adviser, one who is used to working with larger, more complex deals that often use NPV to derive valuations. Then you will need to find more sophisticated buyers who can appreciate the underlying commercial impact of such high growth rates on their investment returns.
In order to get paid the higher multiple you will need to be able to demonstrate sustainability of the high growth rates, but if you have a well-established competitive advantage, a well-defined capacity in your channel to market and a good historical track record, you will have a good case.
Even if you are only able to show evidence of growth for a few years in the future, that alone will kick up your valuation. At the end of the day it is all about the evidence you produce, the reliability of the forecasts and the probability that your buyer can achieve the growth projections.
Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia.