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Multiple of Earnings

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Valuation Technique 1: Multiple of Earnings

For middle-market manufacturers, the multiple of earnings approach is the preferred method of valuation. For such businesses, earnings before interest and taxes (EBIT) is the standard earnings component to which multiples are applied in determining business sale prices. If EBIT shows no earnings, a multiple is sometimes applied to cash flow and even to gross margin.

Let me give a flavor of what some M & A experts have said relative to the multiples to apply to EBIT:

“Will pay 4 to 5 times EBIT if there are growth prospects and no requirements for additional capital.”

“Will pay over 5 times EBIT if net worth is 60 percent or more of the selling price.”

“Will pay 5 to 6 times EBIT for companies with a 15 to 20 percent return on investment.”

“Will pay 5 to 6 times EBIT if there are consistent earnings, good management, and market leadership.”

Mary Young of the Boston office of BankAmerica Business Credit Inc. reported that at the 1994 Buy-Out Symposium in New York City sponsored by Venture Economics, the following observations were made by various speakers:

1. The most common multiple of EBIT is 5 to 7 times for industrial companies and 7 to 9 times for pricing initial public offerings. Thus there is an enormous difference in pricing between private and public companies.

2. It is acceptable to pay up to 7 times EBIT for a stand-alone company but 4 to 5 times for add-on acquisitions.

3. Consumer product companies are selling for 8 to 10 times cash flow.

4. The less a buyer pays for a business, the more he or she can afford to provide for management incentives.

Is the EBIT multiple an arbitrary number? A rule of thumb is that if you buy a new machine for a factory, you should be able to pay for it in five years from the resulting labor savings. Likewise, a business should be able to pay for itself in three to five years, assuming that the earnings remain exactly the same for that period of time. To go one step further, a prudent person might expect a 20 percent return on an investment in a company with steady earnings. On that basis, the company could be paid for in five years at the same earnings level. Therefore, higher or lower multiples are affected by the corresponding difference in the rate of return. Historically, however, a five-year payback has been a de facto standard.

According to Joseph Myss, an intermediary from Wayzata, Minnesota, “The multiplier you select is market driven based on market conditions, comparables, and value in the eye of the beholder. The value the buyer sees in the company affects the market multiplier: Paying 10 times earnings for a company provides the buyer with a 10 percent return on the invested capital based upon historical financial performance. Paying 5 times earnings results in a 20 percent return on invested capital; 4 times earnings results in a 25 percent return.” Myss emphasizes that EBIT is most commonly used as the constant of the multiplier. One needs, however, to separate the acquisition and financing features of the deal. Buyers will use their own capital structure as a model to finance the acquisition of the seller and will look at the company from that perspective.”

* Source Adams - Buying Your Own Business
Identifying opportunities, Analyzing true value, Negotiating the best terms... by Russell Robb

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