Thursday, 13 September 2012

A Multiple of What (and When)?

I discussed the pitfalls of relying on publicly available value comparisons in a recent post but what if an owner of a similar business to yours says “I sold my business at a 10 times multiple!”? or you hear, the tech sector is trading at a 25 multiple.  Early stage companies trade at 2 to 3 times.  The question is a multiple of what?
For public companies the most noted multiple is that of after tax net income.  For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in high growth mode, where profit levels are depressed as a result of higher than long-term average spending on R&D and product/service marketing.  For established private companies, the most commonly cited valuation metric is a multiple of EBITDA. 
EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments).  The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.
The relationship of an EBITDA multiple to other multiples can vary widely across industries.    For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax.  For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven.  When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.
The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a result of the difficulty of predicting what the next 12 months of earnings might be.  Some variants of timeframes used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year.  Why does the timeframe matter?  Let’s look at a fast growing public company such as Apple.  On August 20th, its market cap was approximately $620 billion.  Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBTIDA was $55.8 billion.  People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.
Finally, in addition to the specifics around the multiple, there are many bigger picture questions such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to such questions will also measurably impact the net multiple paid.  So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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