The Hocus Pocus of Business Valuation

“All this talk about multiples makes me dizzy. Multiples of revenue, multiples of EBITDA, multiples of net earnings. Which multiple should I focus on to know my business value?”

Rod (not his real name) owns a profitable healthcare services business. Though just 37 years old, he has assembled an organization and methodology that no longer requires his active involvement in the business. He called me for advice after receiving an unsolicited call from a private equity group. He explained, “The lady who called me told me they were acquiring businesses like mine, and that their recent deals were in the range of 6 to 7 times EBITDA.” Rod continued, “But that confused me because a friend from school just sold his physical therapy business in Oklahoma City, and he told me he got 3 times revenue. So how do I make sense of multiples, or is it just hocus pocus to confuse me?”

Rod is right, understanding business valuation techniques is confusing. In fact, I know many business intermediaries who don’t really know how it works. I explained it to Rod this way, “In reality, there is only one metric that ever matters to a buyer, and it’s not multiples of EBITDA, revenue or anything else for that matter. The only metric that matters to a buyer is return on invested capital. Let me repeat, the only metric that matters to a buyer is return on invested capital.

Yep, that’s right, multiples of something (EBITDA or revenue) do not matter in a business valuation. A multiple is only a shorthand expression of a more complicated formula, return on invested capital. It works like this, let’s say your business has EBITDA of $2 million and you hear that multiples in your industry are 6 to 7 times EBITDA. You’d assume your valuation is $12 to $14 million. But here’s the deal, buyers don’t want you to know their target return on invested capital; if you know how a buyer actually evaluates a deal, you’ll quickly figure out that multiples often mask what the buyer will really pay.

Let’s go behind the curtain for a moment. Financial buyers raise capital from entities that want a return for the investment risk they are taking. No one will really tell you this, but these investors generally need to see a 30% annual return on that investment. How this translates into what they’ll pay for Rod’s business is a function of the capital structure they put on the deal, meaning the amount that is debt and the amount that is equity (a.k.a., invested capital), and the growth rate of the company.

Since all of this can get very confusing, and since the buyer doesn’t want the seller to know how they really look at deals, everything gets dumbed-down to multiples. The buyer assumes the less the seller knows about how they think, the better the deal they can make. If the seller is mesmerized by the hocus pocus of multiples, the buyer will win every time. But if the seller knows the buyer’s targeted return on invested capital, their expected debt/equity ratio, and their projected growth rate for the business, the seller can calculate, with a fair degree of precision, what the buyer can pay for the business. The end of hocus pocus would be good for sellers but not buyers. So don’t count on it happening anytime soon. The only way to protect yourself is to retain a capable intermediary who understands how valuations really work and has the intellectual heft to negotiate with the buyer.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 .  He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.

 

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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