In this article, we outlined the three key approaches towards valuing a business. Today, we are going to take a deeper dive into the market approach which is ideal to value a business for exit planning purposes. As we discussed, the main advantage of the market approach is that it gives real data points of what is actually transpiring in the marketplace, rather than being heavily weighted down by valuation theory. When we are selling a business (or planning on a sale), we are more interested in what is happening in the real world and less concerned with a notional valuation (such as one might find in matrimonial or litigation support matters). Because of this, the weight given to the market approach in an exit planning project is usually higher than in other situations.
For middle market companies, we often examine comparable M&A transactions in the marketplace using proprietary databases. While public companies can be used to assist in guiding our valuations, in most cases public companies will not serve as good comparables for the average Middle Market company. When valuing a company, it is common that the valuator will conclude on enterprise value first before making adjustments to determine the equity value. Enterprise value is the value of the business irrespective of how it is financed with respect to debt or equity. When undergoing a value acceleration or exit planning assignment, enterprise value is more important because it addresses the true health of the business overall. Any improvements we are likely to make in a value acceleration program are primarily done under the guise of improving enterprise value.
Given our focus on enterprise value, the metrics we examine should also focus on firm level valuation as compared to shareholder level values. It is important to understand that there is no one superior metric when it comes to valuation and for some situations, one metric will be more meaningful than another while in another situation a different metric will be more illuminating. Often, enterprise value is referred to as the Market Value of Invested Capital (“MVIC”), and these terms can be used interchangeably.
The key metrics often used in the market approach are as follows:
- MVIC to Revenues
- MVIC to Gross Profit
- MVIC to EBITDA
- MVIC to EBIT
- MVIC to Seller’s Discretionary Earnings (“SDE”)
- MVIC to Book Value
Let’s discuss each of these below along with the pros and cons of each metric.
MVIC to Revenues
In general, revenues are not a great metric to value a company, especially one in the Middle Market. However, there are some occasions when this metric may be useful in valuing a company. In general, any business where the primary asset being purchased is a book of business (such as a services firm), a multiple of revenue may serve as a good metric, especially if the purchaser does not intend to take on existing management, they only want to integrate the revenue into their existing business. Small businesses (with revenues under $1 million) may also be sometimes valued using a multiple of revenue but this may be more due to limitations of the database rather than because it’s a superior metric. In additional, many start-ups or companies with no profits may also be valued based on revenues since multiples of cash flow or earnings are not available.
This metric is generally a poor predictor of value when it comes to businesses with a large degree of cost of goods sold and sales, general, and administrative (“SG&A”) expenses.
MVIC to Gross Profit
This measure has similar pros and cons as a multiple of revenue but is better suited to wholesalers or retailers. Both of those types of businesses may not have much control over their cost of goods sold and thus management must concentrate not on revenues but rather the gross profit of the business to generate an operating margin. However, this metric has similar limitations as found with MVIC to Revenues in that businesses with substantial SG&A expenses may find a low correlation between this metric and the value of the business. On the other hand, for businesses whereby a multiple of revenue makes sense, there are some practitioners who believe this metric provides an even higher correlation to value than a multiple of revenue.
MVIC to EBITDA
It is common in the M&A world to define cash flow as “EBITDA” or earnings before interest, taxes, depreciation, and amortization. In my opinion, a multiple of EBITDA is superior to those based on revenues or gross margins, but the meaningfulness of this multiple in a business with low EBITDA margins may be negligible. Ideally, when using this multiple, EBITDA has been normalized (that is non-recurring and personal expenses have been removed while owner compensation and occupancy costs have been adjusted to local market rates). If possible, when using the market approach, one should examine this multiple within the set of transactional comparables found to at least act as a secondary reasonability test.
MVIC to EBIT
This multiple may have similar usefulness as a multiple of EBITDA for non-asset intensive businesses. Businesses with either very new equipment or fully depreciated equipment may present a distorted EBITDA, Thus, this multiple may serve as a good sanity test to MVIC to EBITDA through eliminating the impact of these distortions.
MVIC to SDE
Seller’s Discretionary Earnings (or “SDE”) represents the earnings of a business before owner’s compensation is considered. In essence, SDE acts as a type of cash flow. This multiple is often beneficial when examining smaller businesses where an owner has essentially created a job for themselves as opposed to larger organizations where there are several layers of management. This metric is likely most useful when examining for any business under $1 million in revenues or where there is only one primary owner-operator.
MVIC to Book Value
This multiple is derived from the book value of a business. For most transferable businesses, the book value is rarely the primary method for the valuation, however, the book value may serve as a good sanity test. For large differences between the enterprise value and the book value, we can compare the difference (we call this goodwill) with annual cash flows to calculate an estimated payback on goodwill to assess the reasonability of the valuation. If the payback period is too long, it may be a trigger for us to reexamine our valuation assumptions. For non-asset intensive businesses such as service-based businesses, this metric may not produce meaningful insight.
Putting It All Together
A recent study was released by Business Valuation Resources that outlined the metrics that provided the highest correlation to value on different industries. Not surprisingly, for most industries, either a multiple of EBITDA or a multiple of discounted earnings (through a discounted cash flow analysis) had the highest predictive value. In only a few industries were alternative metrics such as MVIC to Gross Profit or MVIC to Book Value the best indicators of value. Even in these cases, a multiple of cash flow (either EBITDA or discounted earnings) served as a useful secondary metric.
It’s important to understand that no one metric is superior over the others all the time and that even if one metric is preferred, other metrics have been examined and considered. A prospective purchaser of a business may value a business differently from the seller due to a number of reasons including different assumptions about the business and may weight valuation indications differently. If possible, one should consider the valuation of a business using both the market and income approaches together since both can provide useful evidence with regards to the fair market value of a business. This is especially true when the valuation is performed as an exit planning exercise since the market approach tells us a lot about the market in which the subject company competes while the income approach illuminates us on the growth and risk factors that drive the valuation of the business. It is only through taking a detailed analysis of what drives the value of any business that this information can be used to ultimately improve and maximize enterprise value.
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