What a valuation multiple really means

Ask what a private business is worth and you will be answered with a multiple. Three times earnings. Five times EBITDA. One times revenue. The phrase sounds precise. It hides almost everything that matters.

A multiple is a payback period in disguise

If you pay three times annual profit for a business and profit holds steady, it takes about three years of that profit to earn back the price. The return on the price is roughly a third a year, before tax, debt and your own time.

That is a far higher return than shares in large public companies are expected to produce. The gap is not a gift. It is payment for the things that make a small private business riskier and harder to own:

• The profit is less certain.
• You cannot sell quickly, or perhaps at all.
• The business may depend on a few people or customers.
• You may have to run it yourself.

A low multiple means buyers in general see a lot of this risk. A high multiple means they see little. The price is the market's opinion of how long the profit will last.

Multiple of what?

Two listings at "four times" can be priced very differently, because the figure underneath is not the same.

The difference between the first two matters most. SDE includes the owner's own pay. EBITDA assumes someone is already being paid to run the company. A business with SDE of £120,000 where the owner works full time may have EBITDA of £60,000 once you budget for a manager. Four times one is not four times the other.

Before comparing any two prices, put them on the same measure.

What moves a multiple up

Buyers pay more for profit they trust. In practice, that means:

1. Recurring income. Contracts, subscriptions and repeat customers on a schedule.
2. A team that runs it. The owner can take a month off and nothing breaks.
3. Spread. No single customer, supplier or member of staff the business could not survive losing.
4. Clean records. Accounts that match the bank, year after year.
5. Size. Larger businesses attract more buyers and more lenders, and both push prices up.
6. Growth with a cause. Rising sales for a reason that will continue.

Turn each one around and you have the list of what pushes a multiple down.

Cheap, or just low-priced?

A business at two times earnings is not automatically a bargain. It may be priced that way because the profit will halve when the owner leaves.

The useful question is not "is the multiple low?" but "is the multiple low for the wrong reasons?" The best purchases tend to be businesses priced for risks that a particular buyer can remove:

• An owner-dependent firm, bought by someone who can install a manager and systems.
• A business with poor records and solid trade, bought by someone willing to do the tidying.
• A good small company with no marketing, bought by someone who knows how to bring in work.

In each case the buyer pays for the business as it is and keeps the value of what they fix. The risk is paying a low price for a problem you cannot solve.

Why the same business sells for more later

This is the quiet engine behind many acquisitions. Improve the things in the list above and two numbers rise together: the profit, and the multiple a future buyer will pay for it.

A firm earning £150,000 bought at three times costs £450,000. If, some years on, it earns £250,000 and has a manager, contracts and clean books, a buyer might pay four times: £1 million. Nearly half of that increase came from the multiple, not the profit. The numbers are an illustration, not a forecast. Many businesses never make that journey, and some go backwards.

For early-stage companies

Young companies raising from angels often have no profit to multiply, so the valuation rests on other things: the team, the progress so far, the size of the opportunity and what comparable companies raised at. It is closer to negotiation than calculation. The discipline is the same. Ask what has to go right for the price to make sense, and how likely that is.

The short version

A multiple is a judgment about how durable the profit is. Do not argue with the number. Examine the judgment. If you can see why the market is cautious and you are in a position to remove the cause, you may have found something. If you cannot see why it is cheap, assume the seller can.