A Comparison of a Commonly Used Valuation Multiple to Real World Data

TASA ID: 4374

A few months ago, I had an interesting chat with a very successful proprietor of a contractor supply retailer. He explained that, in his line of business, the sales price of a firm would be three to four times earnings before interest, taxes, depreciation and amortization (EBITDA), plus inventory, less dead and dying stock.

That rule of thumb is quite intuitive. Most of us can easily conceive of the value of a firm as a function of all the cash it will create for its owners. If a firm generates $100 a year for its owners, we can just calculate the present value of a $100 perpetuity using a required rate of return of, say, 28%

$100 ÷ 28% = $357.

If I want to buy a business that will generate $100 a year for me, and my required rate of return is 28%, I should pay $357 for that firm. So the “trading multiple” of this firm is 3.57. Pretty simple.

Assuming that the cash invested in the firm (capital expenditure plus working capital) is equal to the depreciation and amortization incurred by the firm each year, EBITDA actually does equal the free cash that a firm generates for its owners. It’s no coincidence that a lot of heuristics used to estimate the value of a firm are based on some multiple of EBITDA. (Let’s keep this simple and forget about the fact that real capital expenditure almost never equals depreciation and amortization. We’re talking about heuristics, after all.)

Despite this, I have to say I was surprised to hear a seasoned proprietor use such a simplistic approach to come up with a purchase price for a firm. What the heck am I doing using all of these fancy valuation techniques if all we need is this multiple? For fun (or perhaps for fear of the future of business valuation consulting), I decided to take a look at the appropriateness of this multiple approach in the contractor supply retailing business.

The best way to evaluate this is to look at the ratios of price (plus inventory less dead or dying stock) to EBITDA for publicly traded contractor supply retailing companies. Why? Because we know the fair market values of publicly traded firms. The price at which investors are willing to buy and sell equity in a publicly traded firmis its fair market value.

I pulled all publicly traded contractor supply retailers from the Compustat database, and created the ratio as described by my friend in the contractor’s supply retailing business. I calculated the market value of each firm’s equity, minus 90% of inventory (assuming 10% is dead or dying stock), and divided it by each firm’s EBITDA. Using this dataset, I find that the average trading multiple for publicly traded firms is 7.5.

My friend that owns a private contractor’s supply retailing company suggested a multiple of three or four. He owns a private firm. However, we know that there are important differences between the value of a minority ownership share of a publicly traded firm and majority ownership of a privately owned firm. We need to adjust the multiples of these publicly traded firms in two ways. See my article here for a fuller discussion of these important adjustments.

• First, a minority position (i.e. just a few shares of equity) in a firm is worth a lot less on a pro rata basis than a majority position that gives you ownership control of a firm. The difference in value of a majority ownership position and a minority ownership position is called a “discount for lack of control”. 
• Second, ownership in a publicly traded firm is very easy to sell in the open market. It’s more difficult, and costly, to sell a privately traded firm, because of the time and resources required to prepare the firm for sale, and to locate a buyer. The lower value attributable to privately traded firms compared to a publicly traded firm is called a “discount for lack of marketability.”

Let’s adjust my friend’s multiple of between three and four for a privately owned firm to publicly traded equivalents, and see how it compares to what we see in the market.

Turns out that, on average, my friend’s rule of thumb of selling a firm for three to four times EBITDA, plus inventory less dead or dying stock is pretty good! Three to four times EBITDA for a privately traded contractor supply retailer is equivalent to 5.5 to 7.3 times EBITDA for a publicly traded contractor supply retailer. The average actual multiple is 7.5. Not bad at all.

If I put my head in an oven, and my feet in the freezer, on average, I’m comfortable. While, on average, this trading multiple looks pretty good, we have a big problem. The following graph describes the publicly traded firm multiples in more detail.

In reality, 20% of all trading multiples fall below 2.5. 34% of all trading multiples are above 10. Heck, almost 2.5% are above 30!

How bad is it? The mean absolute deviation of all publicly traded firm's multiple is from the average trading multiple is 4.6; the average trading multiple is 7.5. So that means that using the mean trading multiple of 7.5 to value a firm will create a 61% valuation error on average.

What a disaster it would be to sell a firm for 3.5 times EBITDA, plus inventory less dead or dying stock, when it’s really worth much more! In the real world, we would be selling that firm for WELL under its fair market value 34% of the time.

How badly would we feel if we bought a firm for 3.5 EBITDA, plus inventory less dead or dying stock, when it turns out the firm was worth less than half of that? Using real world data, 20% of firms are worth less than half of our heuristic of 3.5 EBITDA.

Why do the values of real firms diverge so wildly from the average trading multiple we considered at the top of this story? There are several reasons. Some firms require significant capital investment because facilities are falling apart. That is like buying a house that needs a new heater and plumbing. This doesn’t show up in an EBITDA multiple. Other firms may be subject to a “key management” discount. The reputation and capabilities of the firm may be inextricably linked to the current owner and management team; any sale to new owners destroys the intrinsic value of the firm.

Perhaps most commonly, almost all firms have very different growth prospects. Let’s keep it simple and revisit our firm from above, which generates $100 a year for an investor with a required rate of return of 28%. That generated a nice trading multiple of 3.57. Let’s now assume this firm has growth prospects of 5% per year.

What would the trading multiple of this firm become?

$100 ÷ (28% - 5%) = $435.

An increase of 5% in growth increases the implied trading multiple from 3.57 to 4.35, which is a 22% difference.

Let’s assume this firm that generates $100 per year is on its way out, and that the firm will shrink by 5% per year. Now what’s the trading multiple?

100 ÷ (28% + 5%) = $303.

A 5% decline in future growth prospects decreases the implied trading multiple from 3.57 to 3.03 – a 15% decline.

Like most rules of thumb, it looks like this one is based in a little bit of truth. But a quick evaluation of the perils of using this heuristic to drive a real deal shows us that a rigorous valuation, which incorporates the unique characteristics of the firm under consideration, can help us to avoid huge mistakes.

This article discusses issues of general interest and does not give any specific legal or business advice pertaining to any specific circumstances.  Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.

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