A higher EBITDA multiple is paid for lower risk, but, the biggest driver in attaining a higher EBITDA 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). However, 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.
Strong Growth Drives a Strong EBITDA Multiple
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, a 4x EBITDA multiple, 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.
What About Managing Risk?
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.
Is the EBITDA Multiple the right metric for most private companies?
For most companies yes, but in certain cases, where there is no EBITDA to speak of, valuators will use a multiple of revenues (for companies that are investing all free cashflow in growing the business) and in some cases, such as for pre-revenue companies, user metrics are used such as average monthly users or video or page views.
Recommended Further Reading
For more on valuation and EBITDA, see: A Multiple of What (and When)?
For more on how to optimize net proceeds, see: Share Sale or Asset Sale: It is Mostly About Minimizing Taxes