By: BerryDunn Professionals, Casey Karlsen, Senior Manager | CFA, ASA and Seth Webber, Principal | CFA, ASA, CEPA
Consider the value of the following two hypothetical companies. Anita owns A+ Manufacturing, a car parts manufacturer that employs 100 people. Roger owns a very similar company, D- Manufacturing, which also manufactures car parts and employs 100 people. These companies are both almost identical, and last year, they generated the same amount of revenue and income. A key difference, however, is in the management styles of the owners. Roger is extremely disorganized and has difficulty with record retention, locating information, and tracking and analyzing data. He is relatively inexperienced as a manager. Anita, meanwhile, is very punctual and organized and has 15 years of management experience. She relies heavily on tracking operational and financial data and makes this information readily available to managers and their teams. She believes in an organized, clean workplace, and her strong leadership and carefully maintained culture have resulted in employee tenure that is much higher than industry standards. Which company is more valuable?
Despite being identical in terms of service offering and size, most people would identify A+ Manufacturing as being more valuable. Alarm bells start to ring in a valuation analyst’s head when learning about the sloppy management style, lack of experience, and poor use of data at D- Manufacturing. The difference in value should be substantial. Despite generating the same amount of profit last year, A+ Manufacturing could be worth twice as much as D- Manufacturing because these risk factors may jeopardize future profits.
In addition to the risk factors from the above example, there are many other drivers of business value.
Valuation formula
In its simplest form, the valuation of a business can be reduced to the following formula based on earnings before interest, taxes, depreciation, and amortization (EBITDA). Factors that affect value do so by affecting the valuation multiple. Companies such as D- Manufacturing would be worth a lower multiple of EBITDA, and a higher multiple would be justified for less risky companies such as A+ Manufacturing.
Estimating an EBITDA multiple
A generic multiple often thrown around is 5x EBITDA. EBITDA multiples from the DealStats database have historically been in this range, but have come down in the last few years, as shown in the accompanying chart.1
Median Selling Price/EBITDA with Trailing Three-Quarter Average
EBITDA multiples vary widely by industry. For example, in the DealStats database, the median EBITDA multiple for retail trade was 3.7x compared to 6.1x for manufacturing companies.2 The chart below presents EBITDA multiples by industry from the DealStats database.
Selling Price/EBITDA Interquartile Range by Industry Sector (Private Targets)
Even within a specific industry, multiples can vary dramatically. For example, from the chart above, the median wholesale trade multiple was slightly above 5.0x, but the 75th percentile multiple for this industry was nearly 10.0x.
Factors affecting EBITDA multiples
Differences in valuation multiples from company to company reflect differences in risk profiles. High-risk companies command lower multiples than safe investments. The following chart illustrates how certain operational risk factors may affect the valuation multiple.
Other factors that affect valuation multiples include the following:
Access to capital
Supplier concentration
Supplier pricing advantage
Product or service diversification
Life cycle of current products or services
Geographical distribution
Currency risk
Internal controls
Business owner reliance
Legal/litigation issues
Years in operation
Location
Demographics
Availability of labor
Employee stability
Internal and external culture
Economic factors
Industry and government regulations
Political factors
Fixed asset age and condition
Strength of intangible assets
Distribution system
IT systems
Technology life cycle
One model to assess risk and select an appropriate multiple is the exit and succession planning software prepared by MAUS Business Systems (“MAUS”). The MAUS Business Attractiveness model assists analysts in assessing and diagramming the risk profile of a company. This model was developed to assess business attractiveness to potential acquirers based on common risk factors. Analysts can use this software as part of their assessment of an appropriate valuation multiple. This model is also a helpful communication tool because it provides a visual representation of a company’s risk profile and highlights the areas in which a company can improve.
Using this model, analysts assess a company’s risk profile regarding several key factors. MAUS then generates a report that includes a series of diagrams like the one below. Business attractiveness factors are positioned around the outside of a polygon. If a company performs well regarding a particular factor, a point is plotted toward the outside of the polygon. If the company performs poorly, a point is plotted toward the center of the shape. The points are then connected to visualize a company’s risk profile.
Business Risk & Value Factors
The larger the colored shape is in the MAUS diagram, the higher the valuation multiple should be. However, these factors do not all affect the multiple equally. The valuation multiple may be highly responsive to some factors and less responsive to others. Additionally, each factor may not have a linear effect on the valuation multiple. For these reasons, formula-based estimates of valuation multiples are often inaccurate, although a great place to start for a ballpark indication of value. For matters of importance where accuracy is paramount, we strongly recommend consulting with a valuation professional. In addition to valuation expertise, an outside party provides an independent, unbiased assessment of value.
Conclusion
The value of a business can be affected dramatically by its risk profile. Analysts value businesses based on a number of different factors that affect value.
Learn what risk factors your company may have and how those affect your business value by downloading our value driver matrix.
1,2 DealStats Value Index 4Q 2023, Business Valuation Resources, LLC (www.bvresources.com).
Original article published on 01.24.24, and reprinted with permission by BerryDunn, https://www.berrydunn.com/business-value