3 Pillars of Valuation
The other day, an entrepreneur friend called me in frustration. He’d been trying to figure out what his company might be worth, and the best information he could find was that multiples in his industry were currently between four and six times EBITDA.” (That’s earnings before interest, taxes, depreciation and amortization.) His point, which I thought was very fair, is that this resulted in a valuation range that was so wide as to be almost useless.
Despite the merger and acquisition industry’s obsession with EBITDA multiples, those numbers are really nothing more than a way of describing how much the marketplace thinks certain companies in certain industries are worth at a particular moment in time. They’re an “output” number that measures what companies are being valued at, rather than an “input” that would be helpful in determining the value of your own particular company.
“Then what,” asked my frustrated friend, “is valuation actually based on?”
I told him that you have to get back to basics: earnings, the quality of those earnings, and creating competition between buyers.
At the most basic level, the more money your company makes, the more it’s worth. Therefore, the best way to get more for your company is to grow the company so it earns more. This increases your book value, but larger companies also sell for higher multiples than smaller companies because their higher growth opens up a larger and more sophisticated market of potential buyers.
Quality of Earnings
Although mergers and acquisitions end up being presented as strategic moves in press releases and articles, at the most basic level any buyer is looking for a return on their investment. That means they want to buy companies with high-growth, stable earnings. The more stable and predictable your earnings are, the more you’re worth. This seems like a no-brainer, but company management often gets distracted by chasing after one new and exciting “next best thing” after another, and forgets all about the attractiveness of a smooth upwards trajectory.
You also need to dig out the risk factors in the way your company is currently operating. If 80% of your business is tied up in one customer, that’s not good. If your product is about to be made obsolete by new technology, that’s not good. Other risk factors include potential government regulation, gaps in your supply chain, how large your potential customer base is--the list goes on.
Not all profits are created equal. This is why basing company valuations on EBITDA multiples or a purely financial analysis can be so misleading.
There will only be a certain number of entities that have both the ability to buy your company and the desire to do so. When it comes time to sell, don’t just go to the guy down the road - reach out to all of them. Putting those buyers in competition increases the amount they’re willing to pay, as the opportunity for gain they initially saw in front of them turns to a fear of loss that someone else might end up with your company’s assets. Remember your Economics 101 class: the only true way to determine a product’s worth is to see what a willing buyer will pay in the free market.
Savvy entrepreneurs use these three pillars to make their business more valuable long before it’s time to sell. Bigger is better, so growth is important. Predictable, steady growth is the most attractive, and “swinging for the fence,” or one-time unpredictable events, are not very valuable. Finally, when it does come time to sell, make sure that you market the company to a large number of qualified buyers, so that the competition in the marketplace will drive your company’s value to a peak.