How is it possible to make an acquisition valuation based only upon earnings multiples in disparate economic environments and business climates? And how heavily should we rely upon “standard” earnings multiples for comparable transactions in an industry?
Most studies of acquisition volumes and values also focus on earnings multiples, in the same way that business owners use multiples as a measuring stick and buyers rationalize purchase price “fairness.” For example, a company with $5 million in EBITDA that sold for total purchase price (consideration to seller) of $30 million would be quoted as a 6X EBITDA multiple. However, is this multiple useful as a valuation comparison for another business in the same industry that might have had $7M EBITDA in 2008 and $3M in 2010? Should that same 30 year-old niche business with a solid financial performance history be worth $42M at one time, then $18M a couple of years later? In the simplest terms, no and we’ll talk more about that in this blog – there are innumerable variables that make up a business valuation, but too often we don’t look further than a multiple.
Recent Acquisition Activity and Earnings multiples
2011 has been very active for M&A activity. When you look at M&A volume historically, volumes are significantly higher in periods when the stock market was posting above average returns, which was the case until this recent sell-off in the last week. In the early stages of a recovery, the market posts above average returns, so it is typical that you would expect higher M&A volumes.
For US middle market deals in the first half of this year, average transaction size has also been up around 40% compared to the first half of 2010. In part, this volume and pricing increase is driven by a herd mentality and fear of missing out. In part, it is due to an availability of cash and need for growth when organic growth has been constrained. It can also be attributed to the fact that higher earnings multiples can coincide with fair and reasonable absolute price.
When business performance is weaker, a business may be valued at a high earnings multiple, and still be a better deal than paying a lower multiple on higher earnings when business is booming. While book value is certainly not the most critical determinant in business valuation, it certainly shouldn’t be overlooked, certainly not for long-term value from an acquisition. After all, an accretive acquisition that builds value over the medium and long term should keep investors, business owners and shareholders happy, even if short-term financial performance is adversely affected.
The premise for considering book value in determining the purchase price may be a useful sanity check for a buyer to consider. Only if you incorrectly assume that returns, cash flow and earnings were sustainable and predictable could it be reasonable that a cyclical company worth an 8X EBITDA multiple one year, could still be valued with a similar multiple in another year with half or double the EBITDA. Again, I’m oversimplifying, but this is just an illustration.
Another stumbling block for fair valuations is comparable transaction valuations – in boom times, acquirers overpay as a rule, while in weaker times; many sellers may accept a lower purchase price, which becomes a self-fulfilling prophesy to underpay or overpay at the beginning or end of a growth cycle. According to a Fortuna Advisors study and CFO article, acquisitions between 2001 and 2004 (beginning of growth cycle) delivered over 30% higher total shareholder return than those between 2005 and 2008 (end of growth cycle.)
So, where are we going with this? Well, EBITDA multiples may be increasing right now, but in many instances, the acquisition to book value still represents a more reasonable valuation than a lower EBITDA multiple when business was booming in 2007 and 2008. As such, it’s reasonable to circumspect about earnings multiples in an unstable economy and look for other tools to appraise the fair value of a company.
I wouldn’t be surprised if I’m reprimanded for misunderstanding valuation concepts or misstating the appraisal of fair value of a business, when in fact valuation professionals already take this into consideration, but it seems that too often that we are looking for a quick fix 5-minute determination of the value of a business, when that is simply not possible. Hopefully this will broaden the conversation to look beyond an EBITDA multiple as it can leave us confused and/or misinformed.