Using Multiples to Value a Business.

Friday, December 9, 2016

     Many business owners talk about multiples of revenue as a method to value their company.  For example, a company with gross revenues of $500,000 would sell for $750,000 using a multiple of 1.5 with the multiple of revenue approach to valuation.  This approach may work in some industries, but it is generally a poor indicator of value. 

     It's analgous to using price per square foot to value a home.  Price psf may be interesting, but it is not the square footage itself that is the driver of value.  The price psf of a home is caused by multiple external factors such as condition, age, lot size, neighborhood, etc.  The primary indicator of value is location.  So, price psf can vary greatly. 

     Potential buyers of your business will want to know a lot more about your business than just the gross revenue.  They want to know about the industry and it's trends, profit and cash flow, profit margins, customer concentration, management, employees, and much more.  It all boils down how much profit the buyer believes the business can generate going forward. 

     A study was done recently comparing the median sales price of businesses to multiples of revenue.  It showed that businesses typically sell for fractions of revenue, not multiples. 

     The amount of money that a business sells for compared to multiples of revenue generated do vary by the type of business.  One reason for this is because profit margins vary by industry.  Generally speaking, manufacturers command a higher profit margin than retail or wholesale businesses.  Thus, manufacturing firms usually sell at higher multiples than the other two business types. So, unless your business is in an industry experience hyper growth rates, than multiples of revenue are probably not relevant.