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Business Valuation Myth #1

Most people go about their daily lives without having to think about their business worth. But come to sell your business, and hey presto, valuation is the only thing you can think about.  A common parallel is selling your house. Come time to move, you’ll find yourself scouring Zoopla to compare prices – it’s an unmistakable itch.

Unfortunately, this is where the comparison stops. Valuing a business is mighty tricky compared to valuing a house!

But if you were to dive into the world of business and accounting books, you will find a magical number: 5

Over the past few years, I have read in countless M&A, accounting and corporate finance books that business valuation comes down to a typical range of 4 – 6 x EBITDA as the norm, 5 x being the average.

As De La Soul once sang it: 5 is the magic number!

Or is it?

Let’s just recap on business valuation principles. There’s numerous ways to value a business, from asset value, discounted cash-flow, gross contribution and so on…however, the ‘EBITDA’ multiple is generally well adopted as the nirvana of valuation models.

You can see why. EBITDA, or Earnings Before Interest, Tax, Depreciation and Amortisation, provides an approximation of free cashflow not taking into account capital purchases. It’s like discounted cashflow, but without the heavy maths. Or the inclusion of capital purchases, but that’s another story…

So does it hold true in the real world?

Well, sort of.

Whilst many firms sell for 5 – 6 x EBITDA, the fact is, some SME companies are valued a LOT higher.

One that caught my eye recently was Comptoir Libanais, a Lebanese restaurant chain. With revenue of £17.7M, the business has floated on AIM at a ~ £50M valuation. That’s a 2.8M x revenue valuation. I don’t have an accurate EBITDA figure, however, with pre-tax operating profit in 2014 of £1.3M, pro-rata to 2015 and you are looking at roughly a 25 x EBITDA valuation plus…

Or let’s take the IT sector. In 2014 mid-cap accounting firm BDO reviewed company exits within the IT Services sector. Average EBITDA multiple was 8.75. For IT Software, the average multiple was 9.75 x EBITDA. The valuation trend since then has been up, not down.

Angel investors, family office and private equity regularly invest at pre-money valuations that considerably exceed our magic 5 number. EBITDA multiples in eCommerce exits regularly exceed 20 x EBITDA.

So what’s going on?

The 4 – 6 x EBITDA valuation is based on the law of averages. Like the average male in the UK is 5’ 11” tall. The average income is £27,600. The average length of marriage is 11.3 years. The fact is, the 4 – 6 x principle does have some basis in fact. But like all averages, it does not describe every type of business.

It is clear that the market will pay much higher valuations.

So what’s the secret?

The trick is to avoid being ‘average’. So, operating a ‘me-too’ company in a slow-growth market with average profitability – yes, you guessed it, you’ll get an average valuation.

The fact is, the market loves certain things. It loves ‘brands’. It loves scalability.

Strike that, it absolutely LOVES scalability!

So if your business can scale easily. And if you have a great (or growing) brand name, then valuation can rise!

If you have a secret sauce (no not an actual sauce), something like ‘IP’ – if you own the rights to something clever that can change the world, or a small part of it – then, you guessed it, valuation can rise.

The market has an appetite for certain sectors. The eCommerce space continues to amaze. But areas such as biotech, education services, IT, healthcare, luxury retail, medical, renewables… these are all on the rise.

Is a 20 x EBITDA valuation the norm? No. But it does happen – and even the most ‘ordinary’ business can think about how it can create shareholder value and edge its value multiple up!

So the message is – to avoid ‘magic 5’, you need to think ‘differentiation’. Harvard Business Guru Michael Porter was on to something. And consider diversification – look at the markets that are valued and consider how your business could exploit growing sectors.

I mean, few companies cannot leverage eCommerce, right?