5 Signs An EBIT Business Valuation Multiple Is Too High

INTRODUCTION:

Everybody wants their business to have as high as value as possible when they go to sell. Quite often they will be told that the business valuation will be subject to an "earnings before interest and tax (EBIT) multiple which typically is 3." However it is dangerous to value a business just on a rule of thumb multiple. For starters, is the correct method being used which may not require a multiple at all.

If the capitalisation method is the most appropriate for a business given the circumstances, whether a cap rate is too high or too low will usually come down to the risk profile of the business.

Here are some examples where a cap rate might be considered to be too high.

Figure 1: When buying a business beware of the 'risk snake' which could come back to bite you.

1. Few Customers Generate Most Of Revenue

Whilst it is true that generally you can make more profit with fewer customers, purchasers will be wary of business valuations that have a high multiple where only a handful of customers make up most of the revenue.

The risk for the buyer is usually higher as should one or more of these customers leave then the effect on the bottom line could be catastrophic.

Customers can leave for a number of reasons but these can include:

• as the vendor is leaving, they may not want to deal with the buyer;
• they hit hard times and go out of business;
• they sell their business and the purchaser users another competitor;
• competitors cut prices;
• new products or services on offer due to technology, design etc make the current offerings obsolete.

2. Market Data

When assessing whether a multiple looks reasonable, it's always wise to do some market research as to what multiples are being paid as a comparative. The issue is though that this information might not be readily available.

If you can as a guide only, review some public companies' data such as price earnings ratios. Small businesses can typically have a multiple around 20%-40% of these. Again seek advice from a qualified business valuer.

Figure 2: Do your research or you could end up with business that just goes around in circles.

3. Business Operates in A Volatile Legislation Space

If the business being sold operates in an environment where government legislation can have an impact on its revenue and profits be careful when assessing the multiple. Operating in such space can have a downward impact on the business value due to uncertainty. If your business has customers for example who smoke and changes to how and where they can consume these are being brought in, this could cause business performance to drop.

4. Key Person Reliance

A business that relies heavily on key people such as the owners or certain employees poses a greater risk for those purchasing as if the numbers the business produces are reliant on such people, when they go, chances are the profits won't be there.

Is your business reliant on you or some key employees so that if either of you were to leave, the business could fall over?

5. Supplier Risk

If the business can only purchase from a small amount of suppliers for its inputs, this poses a number of risks for a prospective buyer of the business. Reasons for this includes:

• lack of ability to control prices being charged;
• what if the supplier goes out of business?;
• poor quality of inputs provided to you leaves you with few options to go elsewhere and may impact on your brand.

CONCLUSION:

There are many things that should be considered when assessing a business multiple when it comes to business valuations. Always query the number based on risk surrounding the enterprise being considered for purchase.

Remember, the higher the risk, the lower the multiple and then the lower the valuation.

You'll be glad you did.