The Math of Valuation Multiples

Anyone who has considered buying or selling a lower middle market business quickly becomes familiar with the term “multiple of adjusted EBITDA,” or the concept that valuation is often based on a multiple of earnings. The appropriate multiple for any particular business can vary, with higher multiples for more attractive businesses, and lower multiples for less attractive businesses.

For example, take hypothetical Business A and Business B, both of which generate $1M in adjusted EBTIDA. Business A is on the market for a 3x multiple, or $3 million; and Business B is on the market for 5x multiple, or $5 million. 

Why would anyone pay $5 million for Business B that makes $1 million, when you could buy Business A, that also makes $1 million, for $3 million? Is the $3 million business a bargain? Or is the $5 million business overpriced? 

Both are possible, given the limited price transparency in lower middle market transactions. But let’s assume that the businesses are actually priced correctly. What does a 3x multiple or a 5x multiple really imply about the historical performance and future growth expectations of each business? Is Business A a better deal than Business B? 

As a first step, consider the multiple in terms of rate of return on each investment.  Specifically, the implied expected rate of return on the investment is the reciprocal of the multiple.   

·         A company with a 3x multiple, implies an annual future return of 1/3 or 33.3% per year. 

·         A company with a 5x multiple implies an annual future return of 1/5, or 20% per year. 

So a buyer who is ready to pay $3 million for Business A is expecting an annual rate of return of 33%, assuming the business continues to generate $1 million each year. The buyer for Business B at $5 million is expecting an annual rate of return of 20%, assuming that business also generates $1 million per year. Both are high returns compared to most publically traded investments. But of course, return is typically correlated with risk, with risk here primarily defined as the chance that income will decline below $1 million per year.  

Higher return = higher risk. Lower return = lower risk. 

The pricing of these two businesses implies that the business with the higher return, Business A, is more risky than Business B. To be compensated for taking on more risk, a buyer would pay less for it.  Business B is less risky than Business A, and therefore the buyer would pay more for it. 

As a seller, figuring out how to reduce the chance that income will decline in your business can (in a perfect world with perfect pricing) help generate a higher multiple in a sale. As a buyer, understanding your required rate of return and the level of risk associated in a transaction can help ensure you pay an appropriate price for any business.  

Let’s look at some factors that potentially reduce risk (and increase multiples) in lower middle-market businesses. They include:

Conversely, factors that increase risk (and reduce multiples) include:

These are just a few examples, and you can probably think of many more factors that increase or decrease risk. This type of analysis also helps us understand why some industries generally receive higher multiples than others. 

While this overview seems simple, each transaction typically has additional layers of complexity. For example, buyers often bring synergies to a transaction that can reduce the risk in a business. Or when leverage is involved with financing the transaction via a seller note, some of the risk of the transaction is transferred back from the buyer to the seller. This is why deals with a seller note often have a higher valuation multiple than those with no note. Finally, actual terms on the transaction are not always completely or accurately tied to risk and performance of the business. Not every seller or buyer has adequate information or reasonable expectations regarding the price of a business given the level of risk involved. Some sellers may be more motivated than others, and the external economy and demand for investment opportunities also drive buyers’ willingness to pay higher prices. 

Another additional consideration and implication for valuation multiples is anticipated future growth. We will address this in a future article. 

As always, there is much more we could add here! But we hope this is some initial food for thought, and please feel free to reach out with any questions or comments. 

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