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Business valuation, topics to be taken into account in market multiples

Our previous posts already reported that the most popular process through which M&A transactions commonly initiate a business valuation, bases on simple multiple of earnings methods for a valuation that allows fixing the overall worth of the transaction. This is a quick, relatively easy formula (depending on many factors, not all multiples will be useful); however, we understand that it should not be taken as a dogma of faith as that system has certain limitations.

This method is based on the fact that the market is a reliable indicator and that. Let’s explain this theory with a clear example: if my neighbour on the third floor has sold his apartment for 160,000 euros and my neighbours across the street have sold theirs in the same month for 162,000 euros, it means: if I want to sell mine… easy calculation: the previous amount will be the value I can give to my property.

Most commonly used multiples in business valuation

In the case of company acquisitions and reorganisations, the most "famous" multiples are the EV/Ebitda (enterprise value understood as the real price of its shares plus its debts divided by its EBITDA) and the PER (share price divided by profits). When it comes to M&A transactions in SMEs, it is very difficult to obtain these ratios for comparable companies. This is due to the fact that share prices in unlisted companies are difficult to obtain (and there are not many SMEs listed on the stock exchange). Similar transactions in the sector are usually observed (if this is possible, at all) and 'like-for-like' magnitudes are compared to the multiples described. One of the most common methods is to divide the transaction price by the EBITDA and find out how many "times" it has been paid for.

Example of business valuation by multiples

For example, if we imagine a business in a certain sector whose partners have decided to fix a price for the sale, the first thing they will do is to identify transactions of similar companies in their sector (if available). They obtain the following data:

Let’s remove the lowest and highest value (transactions 5 and 10 respectively) to exclude those extreme amounts and obtain an average value of 6 times EBITDA. As a conclusion, a reasonable "market value" for the business would be to ask for 6 times the last EBITDA (or an average EBITDA or an expected EBITDA). This is just one example, depending on the sector, other multiples or combinations of multiples can be used. Other formulas can be applied as well; these practices are not strict "laws of physics". Moreover, depending on the sector, non-financial multiples are used (e.g. number of hotel rooms or number of users of the service of my business).

Limitations of business valuation multiples

However, this valuation by multiples has many limitations, among which the following stand out:

  • It does not take into account the debt of each business acquired (acquiring a business with a very large debt is not the same as acquiring another with a cash surplus).

  • The type of buyer (venture capital fund, industrial investor) is not evaluated. Each has a different strategy and objectives when acquiring a business and therefore, each case may have a different willingness to pay.

  • Acquisition of real estate and/or intangible assets acquired together with the business may represent another issue that it not considered, here.

  • EBITDA may be unadjusted and therefore include non-recurring or non-market items, depending on the nature of the business (e.g. directors' credit card expenses).

  • The future prospects of each business are not known. When one acquires a business, the past is fine, but what is really important is what is expected to happen in the future.

All these limitations can be summed up in the fact that, even if we were to accept that the companies in these transactions are comparable to our own, no two businesses are the same. And the fact is that, while my two neighbours have sold their houses for around 160,000 euros, it is possible that mine is worth 200,000 euros for example (it has a better orientation, a renovated kitchen and central heating). Moreover, be careful! Do not mix up value with price (I can offer my house on the market for 300,000 euros, while a multimillionaire comes along and buys it the next day for that price without asking further).

Supporting business valuation by market multiples

This does not mean that using multiples of Earnings Valuation is wrong or incorrect.

In fact, it seems perfectly reasonable that, if transactions between companies of similar size in an industry have been taking place recently in the range of x times EBITDA, then my business transaction may move around those figures. But it would be appropriate to have the particular valuation of my business, which has specific conditions (customers, work methodology, future prospects, expansion plans, market power, backward vertical integration...), sustained by a discounted cash flow method (DCF) or any other method universally accepted in finance to support that valuation range by multiples, or justify that the valuation of my business is above market.

The Discounted Cash Flow method DCF is a more technical, more “scientific” and more laborious method, but precisely for this reason, it provides a more objective value of the company or business within the subjectivity (it is based on premises) as well as being perfectly valid for SMEs.

We at Carrillo Asesores are experts in M&A operations and business valuation. Please contact us. Our Tax Department will be more than pleased to assist you.

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