Gil Roberts: Debunking the Valuation Myth: The Multiple is Fixed
As discussed in Marty Jaffe’s June article (click here), typically, business owners and CEOs think of the value of their business as the annual profit of the business multiplied by a multiple as show below.
Value = Profit X Multiple
A common belief is that the multiple in their industry is fixed and does not change. This is just not true. Let me explain.
Business Owners Know the Industry Multiple: Often business owners have seen companies sold in their industries and, therefore, they have a very good sense of the multiple for the businesses in their industry. Recently, I was talking with a CEO, let’s call her Cindy, about selling her business and she told me that her business was worth $10M. I asked how she knew this. Cindy told me that not long ago a friend of hers with a similar business in the same industry sold their business for $12M and that the multiple in their industry was ‘4’. Her friend’s profit was $3M and multiplied by ‘4’ resulted in $12M. Cindy then shared that her profit was $2.5M and when multiplied by ‘4’ meant that her business was worth $10M.
Increase Value by Increasing Profit: Cindy then told me that she wanted to sell her company for at least $12 million like her friend. Like many CEOs I know, she was going to focus on increasing her business value by focusing on increasing profit. This is what business owners work on every day. To increase profits they grow sales, reduce product or service costs, improve margins and reduce operating expenses. By doing a combination of these, Cindy planned to grow her profit to $3M and then sell in about 2-3 years.
The Multiple is Not Fixed: Business owners, like Cindy, are often surprised to learn that the multiple in an industry is not fixed. In fact, a business owner can significantly impact a business multiple by doing two things, decreasing risks in the business and increasing strategic assets. Stay with me.
Average Multiple in an Industry: Let’s look at your industry. Typically, if you examine all the businesses in your industry that were sold over the past year you would find a wide range of multiples. Some of the companies sold for higher multiples and some for lower multiples. In fact, you could determine the average multiple for the businesses. Often it is the average multiple that many people refer to when they discuss the multiple in a particular industry.
The horizontal line below represents the average multiple in an industry, say ‘4’. If you are an average company in this industry with a profit of $3M then you would expect the company’s value to be $12M.
Two Ways to Increase the Multiple: You can positively impact your multiple by either decreasing risks or increasing strategic assets. Let’s build on the example above. If the horizontal line is the average multiple, then companies with lower multiples would fall below the line. These lower multiples often occur because of risks inherent in the business. Thus, to raise the multiple, risks need to be identified and eliminated. For example, if the owner of a business was selling his company and the management team staying with the business could not execute the business plan, then a purchaser would often discount the business, perhaps by as much as 50% due to this risk. The multiple goes from ‘4’ to ‘2’. Thus, the value of the business above might now be worth only $6M as shown below. The buyer will need to assume the risk of building the management team.
To increase the multiple business owners and CEOs can also focus on increasing strategic assets. For many owners, like Cindy, this is the fun part of the business. Expanding distribution into new channels, launching new product categories and creating intellectual property are a few of the ways to increase the multiple. Buyers pay more for businesses with more runway…companies that have more opportunity for future growth. If the right strategic assets are employed and the multiple increased to a ‘5’ as shown below the value would now be $15M.
As you can see below a combination of eliminating risks and increasing strategic assets while improving profits, say 20% or $0.6M, is nirvana.
$18M = $3.6M X 5
Conclusion: Multiples are not fixed in an industry. As a business owner or CEO, you have more control over your destiny than you may realize. Once understood, you and your management team can develop an action plan that increases the value of your business that incorporates improving profits, decreasing risks and implementing strategic assets. Are you ready to develop this plan?
Gil Roberts, a Partner with AssayCS, was most recently the CEO of an international consumer products company in the San Francisco Bay Area. Assay Advisory helps owners of privately held businesses increase their equity value before a sale. Call him at 415-906-6070, X255 or email: firstname.lastname@example.org.