What Drives A Company’s Valuation Multiple
What Drives a Company’s Valuation Multiple?
Most business owners know their earnings. What they may not know is why one company sells for 3x earnings while another sells for 7x earnings. The difference is usually not the earnings themselves, rather it’s the buyer’s perception of risk. Evaluation of business value is often simplified to the following equation:
Earnings x Valuation Multiple = Business Value
I know my business’ earnings, but what determines the multiple? The equation is simple, but the reality is complicated.
Buyer Confidence Drives the Multiple
The valuation multiple is based on a buyer’s perceived risk in attaining earnings in the future. The lower the perceived risk, the higher the multiple a buyer is generally willing to pay. The higher the risk, the lower the multiple. Expected future earnings can be calculated based on various measures, such as earnings for the trailing twelve months, three-year average earnings, or even “my gut feeling.” What drives business value is not how future earnings are estimated, but whether a buyer believes those earnings are attainable.
Business owners must ask themselves, what will make a buyer believe the earnings are attainable in the future? The answer drives a valuation multiple up or down.
Can the Business Deliver the Earnings?
A buyer’s belief in the earnings starts with the quantitative foundation for the estimate. First, has the company consistently achieved the expected earnings historically? An estimate of future earnings appears more attainable if the company has demonstrated the ability to achieve the earnings consistently, and vice versa. Second, is the accounting data clean, consistent, and coherent? It is important for potential buyers to have peace of mind when reviewing historical financial data and evaluating future earnings estimates. Business value is based on earnings, but a buyer’s belief in the earnings is often just as dependent on the reliability of accounting information.
It needs to be shown that regardless of whether the company is sold, the company can realistically achieve the earnings on a consistent basis. If the buyer does not believe that it can, the multiple will decrease or the conversation will stop altogether. Conversely, if a buyer believes that the company can meet the earnings, or even expand the earnings, the multiple will increase.
Will the Earnings Survive a Change in Ownership?
For many businesses, a change in ownership includes significant operational changes that introduce risk to a buyer. If the current owner plays a significant role in the company, the ability to achieve earnings consistent with historical earnings might be threatened if the owner is no longer actively involved in the business. The more a business relies on the owner’s relationships, knowledge, or daily involvement, the greater the uncertainty following a transition.
Buyers will ask questions like:
- How much goodwill is built up with the company as distinguished from the owner?
- How much “know how” will be lost?
- How will relationships with employees, customers, or suppliers be affected?
Even if an estimated future earnings stream appears conservative compared to historical earnings, a buyer could believe the earnings are unattainable based on the answer to these questions. Business owners can proactively address these concerns by minimizing the threat that an ownership change would have on future earnings. Some things that can be done over time include:
- Fostering the company’s goodwill independent of the owner’s personal goodwill
- Effectively delegating tasks to employees
- Documenting key knowledge or processes and passing that knowledge on to employees
- Building a capable and customer-facing management team
The aim is to build an independently functioning company that a buyer believes can generate earnings beyond the tenure of current ownership. Strengthening this belief drives the value multiple higher, while giving a buyer doubt lowers the multiple or eliminates value altogether.
Final Thoughts
Owners often focus on growing earnings, but increasing value requires more than higher profits. Buyers pay premium multiples when they believe earnings are sustainable, transferable, and capable of future growth. The businesses that command the highest multiples are often those that depend least on the owner and most on repeatable systems, strong management, and enduring customer relationships. Building those attributes takes time, which is why the best time to improve your valuation multiple is long before a transaction is contemplated.
Zach Roseman is a Partner at Hoffman Clark LLC, a CPA and consulting firm specializing in business and intellectual property valuation, forensic accounting, and financial advisory services. He provides objective analysis and expert support in commercial disputes, financial investigations, and litigation-related matters.