This article originally appeared in the December 2019 issue of Smart Business Philadelphia.
In evaluating the estimated value of a company, many experts will use a multiple of the earnings of the company before interest, taxes, depreciation and amortization (EBITDA) and then add cash and subtract debt. This calculation provides a potential investor with the estimated cash flows that they should expect if they would purchase the company. Determining the multiple to use to apply to the EBITDA, however, along with the other factors that contribute to a company’s value, is a more difficult issue.
Why is it that some businesses will sell for higher multiples than other businesses?
Historically, multiples for privately held businesses would range between four to six times EBITDA. However, some businesses will sell for less than four and some will sell for more than six. The main determinant of the multiple is the risk that the buyer is taking when they estimate the cash flow of the company.
Take, for instance, the following examples as an illustration of the effect risk has on the value of one company versus another. If you have a scrap metal company that is highly dependent on the commodity prices of different metals, the EBITDAs in these companies fluctuate widely from year to year based on scrap metal prices. As such, you would not expect these companies to sell at a high multiple. However, if you have a software company that is highly integrated into its customers’ businesses — those customers rent the software on a monthly basis and the customer retention rates are very high — these companies could sell for multiples far higher than a six because the cash flows are highly predictable.
Also, larger companies will typically demand higher multiples because there is less risk. Larger companies tend to have a larger sales force and are therefore not as dependent on a limited number of people for the results of the company. Additionally, larger companies have systems and processes in place for risk management.
Why are interest expenses and depreciation and amortization added back to EBITDA?
Interest expense is an annual expense that the company is going to incur and will negatively impact the buyer’s cash flow. It is added back because the resulting expected cash flow is then reduced by the debt of the company (usually limited to bank debt).
Sometimes depreciation and amortization are added back to EBITDA, and in other cases, they are not. If you have a business that requires replacement of its fixed assets periodically, a buyer will typically reduce the EBITDA by the expected annual cost for fixed assets. If, however, the company does not purchase many fixed assets, there may be no adjustment for the expected cost of the fixed assets.
What are some of the other factors that generally determine the value of a company?
A few key drivers that could help enhance the value of your company include:
- Consistent increases in annual EBITDA.
- A management team that understands the company and the needs of its customers.
- Clear focus on the market with a solid strategic plan for growth.
- A demonstrated ability to change with fluctuating market conditions.
- Risk management processes that are in place and operating effectively, especially with regard to cyber security.
- High return on invested capital.
- A clear succession plan for senior management. ●
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