Business Valuation Multiples & Multipliers, Why Your Business is not just Two Times the Profit

There are a lot of commonly used profit multipliers to determine the value of a business.  You may have heard of ‘2 times the profit’, or any other version of it such as three times the profit as an ad hoc Business Valuation.  The crux of the matter is: Which multiplier applies to your business and how does it fit in to a Business Valuation?

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The short answer is that it is not as simple as pulling a number out of thin air and plugging it into some simple Business Valuation formula. A Business Valuation is affected by many non discrete factors, including, but certainly not limited to, the following:

Industry Type – Rule of Thumb Multiples for Business Valuations

The first variable is the type of industry your business is a part of. Logically speaking, different industries command different multipliers. So, while your friend’s business may have sold for a one and half times (1.5) multiple of the profit, yours might be worth a Three (3) times multiplier of the profit. Here are a few examples:

• Billboard Advertising Companies    12 Times EBITDA
• Bakeries                                                2 times SDE plus inventory
• Injection Molding                                  4.5 to 6 Times EBITDA
• Burger King                                           40% of Annual Sales Plus Inventory

The key to bear in mind is that there are still many other factors that affect whether the Rule of thumb Multiple will be adjusted up or down and even if it actually even still applies to your business. Which leads us to another factor that affects Business Valuations.

Write Offs and the Different Definitions of Profit affect Business Valuations

Another variable that impacts Business Valuations is the definition of profit and how Write Offs are accounted for. Does it refer to the bottom line profit reported on recent tax returns? But what about your write-offs that are not necessary for the successful operation of your business, but legally allowed? How do you account for the profit that you have reduced via these write offs? Getting to that, do these business valuation multipliers refer to the SDE, EBITDA or some other profit formulation. What are SDE & EBITDA? In short, they are the profit of the business with adjustments for write offs. Each business valuation formula relies on differing definitions of bottom line profit, which means it definitely isn’t as simple as saying ’2 times multiplier of the profit.’ Read this post about EBITDA and SDE to learn more about their actual definitions.

Organizational Structure’s effect on Business Valuations

Another variable that greatly impacts Business Valuations is going to be the employee & organizational structure of the business. How many hats is the owner wearing? The more tasks of the business the owner is responsible for leads to downward pressure on the multiplier, which reduces the Business Valuation. Meaning, if the business were to fall apart if the owner was not available for more than a day or two, then the business valuation takes a significant hit. Conversely, if payroll can be cut, it can be viewed as a positive for the Business Valuation, since payroll reductions can be projected and adjusted for.  However, accounting for projected, hypothetical changes get discounted heavily by interested parties, since the numbers are not actual.

Effect of Barriers to Entry on Business Valuations

Business and industries with Higher Barriers to Entry typically lead to higher Business Valuations. One important thing to point out is that in some Industries, the Barriers to Entry might not be distributed evenly in terms of geography. For example, there could be some markets in which building a coin or card operated laundry is not an issue, but there are other markets in which permitting time & costs are significant. In those cases, the barriers to entry are higher than they would be otherwise, which means Business Valuations will vary by region. Which means factors such as Cost & Time to Build out, Time & Cost to receive permits and clearances, Real Estate Restrictions, etc. also have a huge impact Business Valuations. This is another reason that Business Valuations are not as simple as pull a number out of thin air.

Overall Risk Factor in Business Valuations

Long term industry trends affect Valuation Multipliers greatly. For example, Retail Music stores used to be a good brick and mortar business in the 1990s. However, as digital music sales began and increased, the long term industry prognosis was dire. As such, business valuations were severely impacted. Another underappreciated risk factor is comparing two or more businesses in the same industry. The one that has Lower EBITDA/SDE numbers also has an increased risk factor, leading to lower Business Valuation Multipliers than the others.
Customer Concentration also impacts business valuations. If there are too few customers responsible for too high of a percentage of the business’ revenue, then that adversely reduces the business valuation multipliers down.

For assistance with a Business Valuation for your business contact our office, you can reach our Client Care Manager Sonia Chhabra at  (888) 926-9193 or email cs@justelementary.com