How do valuation multiples work for valuing a small business?

Multiples valuation is a market-based way to put a price on a small business. The Business Development Bank of Canada (BDC) lists market-based methods alongside earnings-based and asset-based ones, and explains that market-based approaches calculate a valuation by applying a valuation multiple, which may be based on EBITDA, revenue or other metrics. The idea is simple: take a measure of what the business earns and multiply it by a ratio drawn from the market. The difficulty sits in the two inputs. This guide explains what each one is, why the multiple is never a fixed number, and the mistakes to look for. It does not quote a multiple, because any figure would depend on facts about a particular business and market.

The earnings measure: EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization, and BDC says it helps evaluate a business’s core profitability. BDC also notes that it is not normally shown on an income statement because it is not a measure recognized by Generally Accepted Accounting Principles. That matters for a buyer or seller, since the figure is calculated rather than read from the statements. Because it is calculated, ask for the working: which lines were added back, and why. Revenue is the other measure BDC names as a possible basis for a multiple. A revenue multiple ignores how costly it is to earn that revenue, so two businesses with the same sales can have very different earnings. An earnings measure brings that cost information in, so ask for it.

Normalizing before you multiply

Earnings may need adjusting before a multiple is applied. BDC lists, among common valuation mistakes, failing to normalize earnings by adjusting for special factors such as discretionary and non-recurring items, and non-market-rate revenues and expenses. An owner’s pay set above or below what a replacement manager would cost is one example to check. A one-time sale or a one-time repair is another. Each adjustment moves the earnings figure, and the multiple then magnifies the change, so every add-back should be documented and tested rather than accepted because it sounds reasonable. Ask also whether the earnings are for one year or an average of several. A single unusual year can make the multiple look reasonable when the business is not, and the reverse is equally possible.

Why the multiple is not a constant

BDC says the specific figure used and the type of ratio vary depending on many factors, such as industry and size of the company, market conditions and multiples used to buy or sell comparable businesses. In a separate guide it adds that goodwill, intellectual property and the company’s location can also influence which multiple is used. This is why a number you hear for one sector tells you little about another. When someone offers a multiple, ask what comparable deals it came from, how similar those businesses were, and when they closed.

Common ways to get it wrong

The same BDC list of mistakes includes applying an inappropriate multiplier of EBITDA, and the same article quotes a BDC director saying that you can’t just apply a multiple. A separate BDC guide says that professional valuators commonly use multiple valuation approaches to confirm a fair price. It adds that after arriving at the EBITDA-based figure, a professional business valuator typically seeks to confirm it by calculating the value of the company’s tangible and intangible assets and by checking what comparable businesses sold for. If a price rests on a single multiple and a single year of earnings, treat it as a starting point for questions. Our guide to how to value a business in Canada sets multiples alongside the other approaches.

• Which earnings measure was used, and how was it calculated from the financial statements?
• Which adjustments were made to normalize earnings, and what documents support each one?
• Where did the multiple come from, and how comparable are those businesses in industry and size?
• What other approaches were used to check the result?
• What does the figure leave out, such as the owner’s role, key contracts or debt?

What the result is and is not

BDC says a valuator’s figure is just a guideline for how to approach negotiations in a sale, and that different valuators may not reach the same figure. It adds that valuators generally offer a price range rather than one precise value, and that you can expect a wider range for smaller companies and for businesses in certain sectors, such as technology. A multiple gives a way to frame a conversation, not a price a buyer is bound to pay. If two estimates differ, compare their inputs before comparing their totals; valuators can disagree, and you can ask each one to show the reasons. For how a lender approaches the question, see how lenders value a business.