Business Valuation Using An EBIT Multiple

Thursday 24 January, 2013

by Craig West

A common question asked by many business owners is “what is my business worth?”. Whilst there are certainly some financial and accounting formulas that could be applied to answer this question, there is also a hell of a lot work that needs to be done that is nothing to do with finance or accounting. Rather, information relating to the commercial and operational issues within the business. These then need to be compiled and utilised to determine risk.

Risk is an important aspect of this equation - as like any investment - risk and reward are directly related - in other words the higher the risk, the lower a valuation versus comparative businesses.
Earnings before interest and taxes (EBIT) multiples are a commonly used tool to estimate the valuation of comparable businesses. Occasionally earnings before interest tax depreciation and amortisation (EBITDA) multiples are used. This method also removes the non-cash expenses of depreciation and amortisation and therefore gives you a realistic picture of the cash which might be generated by the business over a period of time - in other words the reward you can expect for your risk.
The most common way to utilise an EBIT multiple to calculate the value of your business, is to find a comparable business and see what EBIT multiple it is currently trading at. Whilst this information is often difficult to find with small privately held companies it is quite easy to obtain for larger listed companies. In fact these numbers - also called price to earning (P/E) ratio - are published in most of the financial newspapers. The issue though is that there is a substantial difference between most listed companies and small privately held businesses, which inherently involve significantly more risk and therefore a reduced EBIT multiple.
One method is to take the multiples for listed companies that are as similar as we can possibly find (although this in itself is often difficult) and then discount that back to account for the increased risk in the small privately held business. In other words a listed company may well be trading at a multiple of 9 or 10 times and we would discount that back to account for a number of factors (see some examples below), so the small private company may well be trading on a multiple of 3 or 4 times.
Some of the common discounting factors relate to:

• Management experience and expertise (including the risk of key man dependence)
  
• Geographic risk (often, small businesses are based in one location only)
  
• Financial and capital risk (small businesses are often restricted their ability to raise capital or debt to fund further growth and expansion of the business)

There are a number of other issues that we would examine when undertaking the valuation, but as you can see, in most cases small privately held businesses can be discounted substantially from the EBIT multiples we see on listed corporates.

In order to maximise the value of your small privately held business it needs to look and feel as much as possible like a large listed corporate body and that is often about reducing risk in as many areas as possible.