Every seller wants to get the largest multiple possible when selling their business. As we have discussed, there is a typical range of multiples that sellers can expect and there is a way to get larger than typical multiples if there are synergies between buyer and seller that are material enough to be quantified into increased value for the buyer. Here we discuss the assumptions behind using a multiple to value a business. In other words we summarize the origin of the use of a multiple to value a business.
There is really only one way to value any company and that is based on a discounted cash flow (DCF) of future estimated cash flows that a business will generate. A multiple is an abbreviated way of applying this DCF approach as we now illustrate.
We begin with the future cash flows of a seller business. The base DCF model uses 5 years of forecasted revenue and profits and ultimately EBTIDA and then an extra year of forecasted EBITDA for which the model applies a growth factor into perpetuity. If we apply the following assumption to the DCF model, we understand the math behind the multiple:
– Assume that the profits/EBITDA of the business being valued will be the same going forward every year, with some constant growth factor.
This assumption allows us to switch from using a discount rate for every future year of earnings/EBITDA, to using just one discount rate (because the annual earnings are all the same), which is called a capitalization rate. We theoretically have to adjust our capitalization rate for our constant growth factor into perpetuity but this adjustment is so minor we ignore it in our simple illustration here. The standard discount rate is 20% and since we are ignoring our growth rate adjustment due to immateriality in this example, this 20% becomes our capitalization rate.
The final step is to apply our capitalization rate of 20% to our EBITDA. Application means we will capitalize our EBITDA by 20%, or divide EBITDA by 20%, or simply multiply EBITDA by 1 divided by 20%, which is 5 (1/.2=5). And we end up with our standard multiple of 5x. So we have simplistically, we hope, illustrated why we can use a multiple to value a business, when really the only way to value a business is to apply a DCF model. So by making some simplifying assumptions, a multiple is simply applying the DCF model to a business, which is the correct way to value a business.
Discount Rate Standard 20%: We mentioned in our narrative above that the standard discount rate used is 20%. As a brief explanation of where this comes from, it is the rate at which we discount/capitalize our EBITDA to account for the risk involved in a company generating relevant EBITDA. The 20% is “built” and compares the risk of a company’s EBITDA with other levels of risk (investing in government treasury bills, junk bonds, etc). The 20% is essentially built by beginning with the lowest level of risk in terms of financial investing which would be short term government securities and then builds to 20% by adding levels of risk to get to the level of risk appropriate for a private company’s EBITDA. This build up method and the factors involved can looked up on a variety of financial web sites and we will not describe its characteristics here.