The madness of industry multiples

I routinely see individual buyers submit low valuations for growth companies based on a simple multiple of the most recent year’s profitability and, worse still, a multiple that uses a weighted average of the prior 3-year earnings. I usually offer you this simple way of looking at the problem.

Let’s take the example of 3 different businesses with identical revenue and profit in the last 12 months:

*Business1 has a track record of 10% cash flow growth over many years and the target market continues to grow.

*Business2 has a track record of long-term consistent cash flow with relatively minor year-to-year variation and the target market is stable.

* Business3 has a track record of steadily declining cash flow over the past few years and the market outlook appears to be unfavourable.

Using the industry standard multiple of earnings for the most recent year, all of these companies are valued the same. Would you value these businesses at the same level? Of course not!

How about using multiples based on the weighted average of the last 3 years’ earnings? A quick review would show that this would lead to the conclusion that Business3 has the highest rating and Business1 the lowest rating! In most scenarios, this answer would be absurd!!

So why did the industry multiples and weighted averages give the wrong results for these companies? How can these companies be valued? I’ll cover the answer to the above question in a different blog post. For now, let’s focus on how you can better value these companies.

Strategic or synergistic value of these companies aside, there are a couple of good answers to this question:

* Use Gordon’s growth model to arrive at a value adjusted for revenue stream growth.

V = E / (RG)

Where: V= Value of a company

E = Annual income stream

R = Required rate of return

G = Long-term projected growth rate of the income stream

* Develops a long-term earnings stream forecast and performs a scenario analysis based on discounted cash flow. This method is more sophisticated and requires spreadsheet knowledge, but can be useful for establishing a range of values ​​in different scenarios.

The valuation obtained by these methods provides acquirers with a reasonable starting point in many acquisitions of small and medium-sized companies. The acquirer should be aware that the real value of these companies has more to do with the strategic or synergistic value of these companies and may be much higher than these simple methods suggest.