When assessing the value of a business, it is important to step back and consider the primary reason an acquirer makes a purchase: To capture a financial return on their investment. So being a financial guy, I start determining the value of any business by looking at how much money can an acquirer expect to receive compared to how much money they will need to invest. Return on Investment or ROI.
A few observations about common methodologies for placing a value on a company:
- Multiple of Sales: I often hear business leaders talk about the value of a business based on a multiple of sales. While a sales multiple is not necessarily something to be discarded, sales without profits is certainly a concern.
- Multiple of EBITDA (Net Cash Flow): I believe a more useful valuation technique is one that puts an emphasis on the net amount of cash a business returns to shareholders after expenses (many times referred to as EBITDA) rather than the gross sales before expenses. Here is a simple example. Assume that a company generates $20 of EBITDA. If the business is valued at 5X EBITDA ($100) the implied ROI for the purchaser = 20% or $20/$100.
- Consider Capital Expenses: One more observation for the real numbers people reading this is that EBITDA includes an add back for depreciation of capitalized assets (example: computer equipment). Yet cash is required every year to keep computers and other capital assets current. So EBITDA is a great start to assessing true free cash, but the annual cash expense of Cap X should be considered too.