Where did the valuation convention of 3-5X EBITDA originate from?
October 25, 2023
by a searcher from Northern Alberta Institute of Technology in Edmonton, AB, Canada
Im having a hard time explaining to the Vendors on my deal (they rolled equity) that companies are typically valued as a multiple of EBITDA, and they keep getting confused and try to add in the value of the equipment plus retained earnings.
Does anyone know where the 3-5X rule of thumb comes from? I thought knowing the history might give me some credibility and them some comfort.
from Harvard University in Atlanta, GA, USA
from University of Tennessee in Nashville, TN, USA
My interpretation: The convention is a function of the risk-reward concept in finance, "The lower the risk, the lower the reward. The higher the risk, the higher the reward." The smaller Small-to-Medium-Enterprises (SMEs) have a higher risk of failure due to generally having lower revenues, net income, and cash flow.
EBITDA is also commonly referred to as 'dirty cash flow' and is used to estimate a business' enterprise value based on a return-of-cash (not too dissimilar to how cap rates are used to estimate real property values in commercial real estate). The higher the risk (or smaller the company), the quicker expected return-of-cash. The lower the risk (or larger the company), the slower expected return-of-cash.
This risk-reward concept is why companies with larger EBITDAs are generally acquired at higher multiples than industry competitors with lower EBITDAs. Essentially, a 4.0x EBITDA multiple comes with the expectation that, on a debt-free basis, an owner can expect to receive a 100% return-of-cash in 4 years' time (25% expected in each year). Similarly, a 8.0x EBITDA multiple comes with the expectation that, on a debt-free basis, an owner can expect to receive a 100% return-of-cash in 8 years' time (12.5% expected in each year). At any multiple, the result focuses solely on what cash flow the business is expected to generate and ignores key attributes of a business, such as the historical or market value of its assets. Something for your Seller to remember: without the assets the business would not generate revenue.
This relationship also carries over into equity investments in general and is why publicly traded companies trade at sometimes ridiculous EPS multiples simply due to their size.
The ease of use is why EBITDA multiples are the dominant metric used to value SMEs. It is not the only way to value a business nor is it a perfect valuation tool. Those with deeper experience and certifications in business valuation can elaborate further.
Lastly, specific to your Sellers, Retained Earnings is a historical record of aggregate profitability from each period. It is a component of the Seller's Equity in the business. If the transaction you are proposing is an Asset Sale, by definition, you are not buying the company's equity; you are buying it's revenue-generating assets.
Hope this helps!