How EBITDA Multiples Work: The Small Business Guide
There are several commonly accepted methods to calculate a business valuation. The EBITDA multiple is one of them.
The EBITDA multiple valuation method is commonly used in mergers and acquisitions (M&A) transactions, which is why it is a popular metric for private equity. As it sounds, the tactic is based on a company’s EBITDA, or earnings before interest, taxes, depreciation, and amortization.
However, determining a company’s EBITDA multiple is not always straightforward. It depends on many factors, like the company’s industry, financial performance, and market trends. Moreover, two interested buyers frequently arrive at a different multiple for the same business; opinion can sway the multiple one way or another as much as logic.
But there are some general guidelines for estimating what your company’s multiple would be, and for determining what a good EBITDA multiple is. We discuss those guidelines below.
How to Determine EBITDA Multiple
Firstly, how do we calculate the EBITDA multiple? The EBITDA multiple is the company’s enterprise value divided by its EBITDA. In other words, a company’s EBITDA multiplied with its EBITDA multiple computes the enterprise value. These equations look like:
EBITDA Multiple= (Enterprise Value)/EBITDA
Enterprise Value= EBITDA Multiple X EBITDA
The enterprise value is equivalent to what the company would be worth in a sale. Put this way, it is easy to see how the EBITDA multiple is crucial to understanding a company’s valuation.
But while these equations are helpful if both the enterprise value and EBITDA are known, frequently company owners would like to determine their business’s multiple without knowing enterprise value. So, what then?
Factors Affecting Multiples for Small Businesses
Clearly, a higher EBITDA multiple means a company is worth more. But what factors drive the multiple up? In general, the single biggest factor is a company’s growth potential. If it is clear that a business has high growth potential, it is worth more to interested buyers. Why? Simply put, there is more potential for a large return on investment, which every buyer desires.
The competitive landscape is another significant factor. If the company in question is a market leader, this can kick the multiple up. This, again, increases the likelihood of a higher return on investment, therefore lowering risk. On the other hand, if the company in question is a commodity business with low margins battling neck and neck with its competitors, there is less promise of a significant return on investment. It will take more effort and resources from the buyer to get the company to outpace its competition. This, in turn, can lower the EBITDA multiple. Some industries are naturally more competitive than others, which is why the average multiple can vary widely depending on industry type.
Financial performance is also key. The higher a company’s profitability and revenue, often the larger the multiple. EBITDA, itself, is a metric of profitability without taking into account interest, taxes, and other expenses. Therefore, it follows that a company with a higher EBITDA will also have a higher EBITDA multiple. While this is often true, a company’s exact multiple depends on other factors as well— like those mentioned above.
Lastly, current market conditions also weigh in on a multiple. In prosperous economic times, multiples can be higher across the board, regardless of industry. The reverse is true in periods of declining economic activity. This is why many private equity firms try to buy a company in periods of decline, and sell when the economy is booming.
1719 Partners does not look to time the market in its buy-sell transactions, as it invests in companies for the long term. When approaching a transaction from this perspective, market timing takes a backseat in comparison to the company’s potential.
What Is a Good EBITDA Multiple by Industry?
While exact multiples depend on company-specific factors, there are industry averages. This is because not all industries are created equal, and some sectors typically exhibit higher growth potential than others.
Companies in the technology sphere usually enjoy higher multiples. This is due to the fact that, on average, technology companies exhibit a high potential for growth. Comparatively, manufacturing companies often have lower multiples. But it is important to remember these are just averages. A technology company could be just another startup in a sea of companies trying to do the same thing, and a manufacturing company could be producing a groundbreaking piece of equipment.
Manufacturing Multiples
EBITDA multiples depend on the company’s EBITDA or revenue as well as industry type, and manufacturing companies are no exception. For example, an automotive manufacturing company with an EBITDA from 1 to 3 million might have a multiple of 4.5. For the same EBITDA range, a food and beverage manufacturing company might have a multiple of 5.5. When broaching the subject of what your company’s multiple might be, finding the industry average for a company of your size is a good starting point. But just as stated above, the exact multiple depends more on your company’s specific financials than industry averages.
The multiple also depends on a third factor: the prospective buyer. One interested buyer may see a huge investment opportunity where another does not, and so a company’s EBITDA multiple even varies among interested buyers.
So, What is a Good Multiple?
What EBITDA multiple is “good” is a matter of opinion. Of course, higher is always better. But to answer the question more specifically, a good gauge is to compare your company’s multiple to the industry average. If it falls above the average, that is considered high, and it can be assumed that your company’s performance and potential stand out in your industry.
At the same time, if your company’s multiple is below average, it may make sense to examine how you can improve company performance before selling. With this in mind, a good multiple for an automotive manufacturing company may look quite different from a good multiple for a technology company coming up with the new and improved AI algorithm. The important thing to remember is it is all relative.
When evaluating companies, 1719 Partners focuses on the company’s holistic performance and potential more than its industry. We examine a company’s unique assets with the specific perspective of long-term potential. If you have further questions about EBITDA multiples or are curious what yours could be, please contact us and we would be happy to help.