Understanding the Value of Your Business
Two well-known valuation methods can determine how much your business is worth.
If you own a company that participates in the global adhesives and sealants industry, you’ve likely enjoyed several years of sustained growth bolstered by the performance of major end use sectors such as packaging, construction, and automotive. Driven by strong infrastructure development indicators and continued focus on vehicle weight reduction for better fuel performance, market demand is set to exceed $50 billion by 2023.1
Amid recent and continued market optimism, you’ve likely wondered how much your business is worth. Attempting to answer this question through your own research, you’ll quickly realize that there are a range of potential valuation methods; these can seem overwhelming and very often lead to more questions.
Nevertheless, your research will probably uncover two well-known valuation methods: market capitalization (i.e., the total value of the issued shares of a publicly traded company) and asset valuation (the valuation of a company’s tangible assets on an orderly liquidation, “in-use,” or other basis). While these two approaches may provide insight into how much your company is worth, both can also be misleading. Public companies will generally command a higher valuation due to the ease with which their shares trade, as well as because they are often much larger, more established businesses. On the other hand, an asset valuation method may undervalue your business (particularly if your company generates strong cash flow) because it focuses exclusively on the hard assets of the company without taking into account its earnings potential.
Accurately Measuring Value
A different method provides a more accurate measure of value for private companies and is often used in mergers, acquisitions, and transactions involving private equity (PE) firms. This method is called the enterprise value (or the market value of its capital debt and equity net of cash) multiple method, or “EV multiple method.”
The EV multiple is the ratio between a company’s enterprise value and its earnings in order to arrive at a going concern value for the business that is independent of its capital structure. This is very useful for private-equity firms when comparing the value of privately owned companies. The numerator is a company’s enterprise value and the denominator is 12 months of earnings as defined by EBITDA (earnings before interest, taxes, depreciation and amortization). For example, an EV multiple of 8 indicates that the acquirer is willing to pay eight times the company’s current or future EBITDA.
This method can be impacted by a variety of factors, including financial, business and management. A good rule of thumb is that if the offering multiple is substantially higher than the average multiple for comparable transactions, the target has certain factors that someone may perceive as being superior to its peers.
While EBITDA is a fairly straightforward calculation, using the company’s income statement, it is very often adjusted to include certain one-time and non-recurring revenue or expense items. Making these adjustments is important because it normalizes the company’s earnings by excluding items that would otherwise not recur under new ownership or in a “normal” year.
Adjusted EBITDA is also useful because it recognizes that private businesses are often managed to minimize income taxes and reported income. A business owner may charge personal expenses like a private vehicle or charitable donations to the company’s income statement. As a private equity buyer, we increase EBITDA or add back any owner-related expenses that would likely discontinue under private equity ownership. Since higher EBITDA results in a higher valuation, adding these expenses back to EBITDA benefits the seller, while more accurately reflecting the company’s earnings.
So what does the multiple mean? The EV multiple is a relative valuation method. Instead of a direct valuation method, which indicates whether a company is fairly priced, the relative valuation method shows only whether it is fairly priced relative to a benchmark or peer group. This type of valuation method tends to be the “method of choice” for PE firms, since many want to confirm that the EBITDA multiple offered to acquire a company is in line with the EBITDA multiple paid in historical acquisitions of other adhesives and sealants businesses.
For example, Company A, which generated a last-12-month (LTM) EBITDA of $5 million, may be the clear market leader in its sector and/or have a more automated or efficient manufacturing process that allows it to generate a higher gross margin than its peers. As a result, it may garner an 8 times EV multiple (or a $40 million purchase price) vs. an average of 6.5 times for other transactions of similar businesses. Conversely, a lower multiple may indicate the target has certain negative characteristics that make it less desirable or a riskier investment than its peers. Examples of this may be customer concentration, greater exposure to one or more cyclical end markets, and/or lack of management depth.
Following an analysis of the target’s business, financial profile, customer relationships, and management, among other items, a financial buyer will independently determine its own view of EV multiple. Since valuation is a key driver of return, a buyer needs to make sure that the price it is offering to pay for the company generates an acceptable equity return over its expected investment period. It does this by preparing a comprehensive financial forecast based on diligence and information provided by the seller and/or management team. A company’s projected cash flow combined with an input for entry valuation and an assumed input for exit valuation will generate an estimated rate of return for the equity a buyer contributes. If the return does not meet a firm’s minimum internal hurdle, the firm must either lower the price it is offering to pay for the target (i.e., lower the EV multiple) or change certain assumptions within its forecast to compensate for paying that particular price.
If you are considering selling all or a part of your business, it is important to appreciate all the different ways of valuing it. Your equipment may have tangible value, but your cash flow does, too. You deserve to know what your company is really worth, and using the EV multiple method could result in a higher price tag for your business. ASI
For more information, visit www.huroncapital.com.
1. Global Market Insights Inc., April 2016.