Tag Archives: valuation

How Do I Attract a High Multiple for My Business: The Business Factors

There are two broad answers to this question.  The first concerns the business itself and the second concerns the sale process.  The how, when and why of selling.  I will address the business issues in this post; not to say invent a new mouse trap but from the perspective of what factors you can influence in your existing business to improve value.

In “The Basic Math of Valuations” I presented the risk return curve.  A company will attract a higher multiple if it moves to the left on the risk return curve; i.e. a higher multiple is paid for lower risk, but, the biggest driver in attaining a higher multiple is a company’s profitable growth prospects, and, this should already be evidenced by a historical growth record.

Let’s look at the public markets for an illustration.  The dividend discount model asserts that the fair value of a stock is the present value of all future dividends.  The formula is as follows: fair value of a stock = DPS(1) / Ks-g, where the expected future dividend stream is divided by the required rate of return (Ks) minus the expected growth rate (g).  If a dividend is $5.00 and the required rate of return is 20% then the fair value of the share price is $25.00 ($5.00/0.2) according to this model.  If the expected growth rate is 10% then the fair value jumps to $50.00 ($5.00/0.1).  The growth rate lowers the required rate of return and increases the fair value of a stock.  In this case, 10% per annum growth translates into 100% price improvement.  That is a tremendous amount.  The real world experience is not as exact but the illustration demonstrates the logic and impact of growth prospects on company value.

The same logic applies to EBITDA growth for private companies.  Returning to the example provided in the previous post – a company sustainably generating $5 million in EBITDA is valued at $20 million, four times EBITDA, the equivalent to generating a 25% return on capital per annum – if this company were growing at 20% per annum, the multiple could quite readily improve to 6 or 7 resulting in a valuation of $30 to $35 million.  Again, not quite as exact as the formula but the results are still very substantial.

Now, turning our attention to reducing risk, here are some factors to consider:

Is the owner redundant?
The first thing to address when considering selling a business is to put a strong management team in place that can run the business without the owner.  An owner-operator who is the chief product developer or maintains all of the customer relationships will not be able to exit the business upon its sale.  He/she will have to commit to staying with the business until a suitable replacement solution is implemented.

Is the customer base diversified?
The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a smaller company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value the associated risk of these revenues will reduce value.

Are the revenues recurring or project based?
Does every fiscal year start at zero?  What I mean by that is, if your revenues are project based then you are always searching for the next deal.  Consulting companies typically face this challenge.  Along the same lines, a one product company is more risky than a diversified product and services company.

These are three examples of situations where reducing the risk will increase the multiple but the concept applies in general; any combination of improving profitable growth prospects and reducing risk will increase the value of your company.

Four Companies That Know How to Acquire

There have been numerous studies on the difficulties of successfully completing acquisitions.  Some studies note that 50% of all acquisitions fail.  I won’t debate what is a success or failure and over what time frame it should be measured here; what I will do is review four leading Canadian software companies and examine their acquisition records.  The four companies are Constellation Software Inc., The Descartes Systems Group Inc., Enghouse Systems Limited, and Open Text Corporation.  I have reviewed the acquisition transactions where financial metrics were available for the period from May 18, 2006 (the IPO date of Constellation Software) to September 30, 2014 and the following summarizes the results.

Acquisition Summary

The four companies had a combined Enterprise Value (EV) of $1.2 billion in 2006 which grew to $14.9 billion as at September 30, 2014, each generating double digit annual returns.

The challenge in attributing this value creation to an acquisition strategy is that not all acquisitions disclosed payment terms.  Of the 172 acquisitions completed in total, 82 had disclosed financial terms.  What we can assume about the acquisitions without financial disclosure is that they would have been relatively small.  The Ontario Securities Commission requires the filing of a Business Acquisition Report (BAR) when the target size is greater than 20% of the pro-forma combined company.

In looking at each company specifically, we discover a number of interesting metrics.

Of the 22 acquisitions with disclosed financial metrics completed by Constellation, only one was of a size (as measured by enterprise value) greater than 10% of the size of Constellation.  The average size of the acquisitions, taking out the one bigger one, was 1.7% of the size of Constellation.  The median target acquisition price paid was 1.2 times revenues and 5.1 times EBITDA.

Of the 23 acquisitions with disclosed financial metrics completed by Descartes, three were larger than 10% of the size of Descartes and the average size of the acquisitions, taking out the three bigger ones, was 3.0% of the size of Descartes.  The median target acquisition price paid was 2.8 times revenues and 8.8 times EBITDA.

Enghouse was quite a bit more aggressive than Constellation and Descartes, of the 16 acquisitions with disclosed financial metrics completed by Enghouse, five were of a size greater than 10% of the size of Enghouse.  The average size of the acquisitions was 12.7% of the size of Enghouse.  The median target acquisition price paid was 0.9 times revenues and we were not able to deduce a meaningful EBITDA multiple.

Finally, of the 21 acquisitions with disclosed financial metrics completed by OpenText, again, only two were of a size greater than 10% of the size of OpenText.  The average size of the acquisitions, taking out the two bigger ones, was 2.5% of the size of OpenText.  The median target acquisition price paid was 1.2 times revenues and the EBITDA multiple was not meaningful as a number of the targets were incurring losses at the time of the acquisition.

From the acquisitions with financial disclosure, we know that 82 acquisitions cost approximately $2.7 billion.  If we assume the acquisitions without financial disclosure were completed at each company’s average acquisition metrics, then this would add another $2.5 billion to the cost.   Based on these assumptions, a total of $5.2 billion was spent on acquisitions and $8.6 billion in value was created, suggesting the acquisition strategies created tremendous value.  While this is not perfect math, the simple truth is that when you look at the share price, each company has outperformed the TSX by a wide margin over the last 8 years.

There are many ways to study acquisition performance, from large worldwide/all industries studies to sector and geography specific studies.  While this data set is small, what we have observed is that the profiled companies have completed many small acquisitions.  There are a few bigger ones, but we would not call them transformational – those are the hard ones.  What we see here are a series of small, formulaic/cookie cutter acquisitions, rigorously held to reasonable valuation and payment terms.  Integrating acquisitions is hard but what this overview tells us is that if you establish strict parameters around size and value and you do enough of them, you get pretty good at it.