What’s my Multiple?
People often talk about the value of a business in the context of a multiple. Speaking in terms of multiples is not unreasonable. But you should probably be aware that most valuation analysts are most likely thinking about capitalization rates instead of multiples.
Business valuation depends on risk analysis. Given the risk, how much of a return would somebody need in order to invest in this business? Capitalization rates…..cap rates for short…are a quantification of risk. As perceived risk goes up, so goes the cap rate. As risk goes up, the multiple goes down (and the value goes down).
If you ask me about your multiple, I’m not trying to avoid the question. Yes, multiples are influenced by industry. Yes, industries with higher capital requirements often have lower multiples. No, I don’t have a table memorized. But more importantly, I don’t really think in terms of multiples. I think about it as a cap rate. A cap rate is the inverse of a multiple (1 divided by the multiple):
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If you say it’s a 5x multiple, in my head, I’m thinking….oh, they mean a 20% cap rate.
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If you’re talking about a 3x multiple, well, first I wonder if you’re talking about SDE or EBITDA. Then I think….that’s a 33.3% cap rate.
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A 4x multiple is a 25% cap rate. A 6x multiple is a 16.67% cap rate.
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If you mention a 10x multiple, well, first things first, I want to make sure you are awake and not dreaming, but this is a 10% cap rate. And so on.
Imagine you have a great big pile of cash. You want to decide what to do with it. From less risky to more risky:
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If you want to be low-risk, US Treasuries might be a pretty good benchmark. Short term rates right now are probably in the range of 3.5% to 3.75%.
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CDs are pretty low-risk, as well. Rates and risk might be a bit higher than US Treasuries, and there might be limits on the amounts of FDIC coverage, but I’d suspect one could find CDs in the 4% range right now.
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Corporate bonds might be the next tranche of risk. AAA rated bond funds might be 5-6%, and the higher the risk, the higher the return. Lower-rated bond funds might be closer to 7%.
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An S&P 500 index fund is often considered to be a good long-term investment. It would be considered higher risk than a CD. I’d imagine that a long-term expectation might be in the range of a 7.5% to 8.5% return. For smaller cap stocks, one might expect a higher risk…and higher return. (People do talk about “multiples” here, as well. They use the term “P/E ratio” or price-to-earnings multiple.)
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This is not always an easy market to find, and arguably there are multiple markets at work, here, but I might loosely refer to the next risk tranche as Mid-Market Private Equity. Yes, I realize I’m simplifying a complex web, but I’d say that people probably expect returns of 15% at a minimum.
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By the time we get to Main Street small businesses, we might be talking about returns of 25-30% on capital to justify the implied risk. Most of these investments are done with a mixed capital structure, so we can certainly see “multiples” that exceed 3x to 4x, but I think it’s fair to say that the risk-adjusted required return on capital for small businesses starts in this range.
Why does this matter to you? Well, if you’re thinking about multiples, there might be a natural tendency to stair-step them. You might be thinking about a business in terms of a 4x or a 5x multiple of EBITDA. But there is a 20% difference in value between a 4x and a 5x!
Valuation, in theory, is simple. V=B/R. Value is a benefit stream divided by a risk metric. In practice, things get complicated, but in theory it is mostly those two variables.
In my experience, people go to wild extremes when quantifying their B, or benefit stream. It’s actually quite humorous at times. Folks will “add back” just about anything to the benefit stream if they think they can get away with it. Not long ago, I saw a preparation for a bar and grille. They tried to “add back” something like $7 per month ($84 per year) for the cost of the spray fragrance refills they used in their bathrooms. Sorry, but that is NOT discretionary and you do NOT get to add that back! If the bathrooms stink, the business has materially changed! On a $4mm top line, the juice might not have been worth the squeeze.
From my perspective, people want to be incredibly granular about the B, or the benefit stream. Often, they want to argue about $7 per month! Then when it comes to the R, or risk metric, (or more precisely, the inverse,) the approach to that multiple might be rounded by 20%! Is that a 4x or a 5x? Sure, people might think of non-integers in that situation, but rarely does it get more granular than maybe something like 4.5x….still a 10% stairstep.
I don’t mean to be annoying, but if you ask me about your multiple, you might not get the straightforward answer you hope to get. I’ll probably try to explain that a cap rate is the inverse of a multiple, and that’s really how I think about it. I’m not trying to be a know-it-all. But if you are going to be granular in your approach to the benefit stream, you might not want to round off your notion of risk to the nearest 20%.
If you want to know more about risk, the elements of the cap rate, or how we quantify those numbers, I’m happy to chat! Reach out any time!
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