| The folly of industry multiples | | | | give wrong results for these companies? How can |
| I routinely see individual buyers coming up with low | | | | you value these companies? I will cover the answer to |
| valuations for growth businesses based on simple | | | | the former question in a different blog entry. For now, |
| multiple of the most recent year's profitability and, | | | | let's focus on how you can better value these |
| worse yet, based on a multiple using a weighed | | | | companies. |
| average of the profits from the preceding 3 years. I | | | | Setting aside the strategic or synergistic value of these |
| usually offer them this simple way of looking at the | | | | companies, there are a couple of good answers to |
| problem. | | | | this question: |
| Let's take the example of 3 different businesses with | | | | * Use Gordon Growth model to arrive at a growth |
| identical last 12 month revenues and earnings: | | | | adjusted value of the earning stream. |
| * Business1 has a history of cash flow growth of 10% | | | | V= E / (R-G) |
| over many years and the target market is continuing | | | | Where: V= Value of a company |
| to grow. | | | | E = Annual earning stream |
| * Business2 has a history of a steady cash flow for a | | | | R = Required rate of return |
| long time with relatively minor variation from year to | | | | G = Projected long term growth rate of the Earning |
| year and the target market is a stable. | | | | Stream |
| * Business3 has a history of steadily declining cash | | | | * Develop a forecast of long term earnings stream |
| flow for the last several years and the market outlook | | | | and conduct scenario analysis based on discounted |
| appears to be unfavorable. | | | | cash flow. This method is more sophisticated and |
| Using industry standard multiple of most recent year's | | | | requires spreadsheet skills but can be useful in |
| earnings, all these business are valued the same. | | | | establishing a range of values under different |
| Would you value these businesses at the same level? | | | | scenarios. |
| Of course, not! | | | | The valuation arrived by these methods gives |
| How about using multiple based on weighed average | | | | acquirers a reasonable starting point in many small to |
| of last 3 years profits? A quick check would show | | | | mid-market business acquisitions. The acquirer should |
| that this would lead to the conclusion that Business3 | | | | aware that the real value of these companies has |
| has the highest valuation and Business1 the lowest | | | | more to do with the strategic or synergistic value of |
| valuation! In most scenarios, this answer would be | | | | these companies and can be much higher than what |
| preposterous!! | | | | these simple methods suggest. |
| So, why did industry multiples and weighed averages | | | | |