When an EBITDA Multiple Doesn’t Work for a Valuation

Owners often say they want to sell for strategic value. But when they’re questioned further, what they really mean is they want to sell for more than an EBITDA multiple. Whatever their particular industry metric — whether it’s total revenue, monthly recurring revenue or EBITDA — the owner believes she should get more than that when she sells. In this article, we will identify several instances where traditional multiples fall short in determining the value of a business.

During Aggressive Growth

The first strategic value case is for a company that is growing its sales rapidly. If you dissect how they’re accomplishing this growth, you often find that they’re investing all of the cash generated from operations back into the business. Typically the returns from such investments as research and development, hiring sales people, marketing campaigns, and systems upgrades are delayed. The returns may be realized 2–4 months later in terms of marketing expenditures. For adding sales people, the break-even usually takes 9–12 months. R&D takes even longer to return. Compare this to a business in the same market niche that is satisfied to maintain status quo and simply milk their cash cow. The EBITDA performance for this company is going to be far better than the aggressive growth company.

From an EBITDA valuation perspective, the aggressive growth company will actually be punished for a behavior that a future buyer will benefit from. You are actually lowering your EBITDA in order to achieve future higher sales and profits. Business buyers will attempt to paint the selling company with the same valuation brush in an effort to buy them at a bargain price.

When You’re Investing in Your Business

Let's look at a couple of valuation management scenarios for the sale of your business. If you know a time frame where you are going to put your company on the market, you should plan these expenditures. If you know you’re going to sell within the next year, it’s generally not a good idea to grow your sales force during this period. Most sales people don’t become productive for 9 months to a year and will therefore drag down your EBITDA during this ramp-up period.

Also, most sales people don’t make the grade. If a new sales person is a $60,000 drag on earnings and your EBITDA multiple is 6, you just cost yourself $360,000 in lost company value. R&D, again, because of the long period before seeing a return, is not something to start in the last year leading up to your business sale. The same holds true for major systems upgrades or long-term marketing campaigns.

Now, if you’re approached by an unsolicited offer, you can’t retroactively control these expenditures because you didn’t anticipate being for sale. If this is the case and you are in the middle of a new R&D initiative, onboarding a new salesperson or doing some major systems upgrades, you should attempt to quantify the impact of these on your current EBITDA and argue for an EBITDA adjustment or add-back.

If You Have Stored Value

If you look at the Biotech industry, you will see some very high valuations because they are very front-end loaded on expenditures. Think of the amount of time and money it takes to get a new drug approved. During the gestation period, these companies don’t perform well from a cash flow perspective, but are creating tremendous potential value. So, if you are a business that has a great deal of stored value that can soon be realized by a larger strategic buyer or private equity group, an EBITDA valuation will not capture that.

This might be the case for a software company that has a large base of users on a Freemium version of their software with a paid version update available. A business model where the next unit of product delivered has close to zero cost definitely breaks the EBITDA valuation model. Software is a great example of this, as are content, music, Web Services and customer self-service models (like Google Ad Words).

What Works Instead? Price to Earnings

In the publicly traded stock market, the broad metric for company valuation is the P/E multiple (price to earnings). Some sell at a P/E of 11 — the average is 16 times — and others are 50 or higher. So, assuming 1 million shares outstanding and various P/E multiples, the total company value math is as follows:

So the sophisticated investors value companies with a base average multiple of 16 and apply their own strategic value enhancers with the most powerful factor being the growth rate of sales and earnings. In fact, a relatively recent addition to the valuation tool bag on Wall Street is the Price/Earnings/Growth multiple. Let's say you're analyzing a stock trading with a P/E ratio of 16. Suppose the company's earnings per share (EPS) have been and will continue to grow at 15% per year. By taking the P/E ratio (16) and dividing it by the growth rate (15), the PEG ratio is computed to be 1.07. So a PEG ratio of above 1 is considered a premium price, below 1 is considered to be value priced, and equal to 1 is considered fairly valued.

If you have an existing product that can be used for another purpose or expanded to another market segment, you have a compelling argument for strategic value. A low-tech example of this is Arm and Hammer baking soda. For its first hundred years, it was, well, baking soda. Later, the deodorizing properties were discovered and the company’s sales exploded. A high-tech example is Nvidia, the maker of the Graphics Processing Unit for computer gaming. These remarkable chips became the preferred chip for artificial intelligence, then self-driving cars, then the big data centers, and finally Bitcoin mining. Talk about an explosion in value.

If you are positioned to be out in front of a technology trend like Internet of Things or Artificial Intelligence, you could be highly valued in the market. The same is true if you are well-positioned in front of a coming social trend or governmental regulations.

If you’re a smaller company, it’s difficult to optimally capture all of your strategic value without the benefit of additional capital or your acquisition by a larger company or private equity group. The key in driving your value to one of these buyers is to articulate the stored value you have created and to model the impact of combining with their firm to create strategic value. You will be handsomely rewarded if you can show the buyer how 1 + 1 = so much more than 2.