Pick a winner: Understanding business valuation pricing multiples

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Courts often prefer the market approach for its perceived objectivity. But, like any technique, the market approach requires some professional judgment. Truly comparable market data can be hard to find, especially when valuing smaller private companies. Equally challenging is answering the question: What should the selling price be compared to?

The optimal “pricing multiple” depends on the nature of the company’s operations and the factors that drive value in its industry. Here’s an overview of common pricing multiples, along with some of their pros and cons.

Multiple pricing multiples

Under the market approach, a business’s value is derived by comparing it to real-life transactions involving similar companies. There are two main sources of data to use when applying the market approach:

1. Public stock prices. The guideline public company method develops pricing multiples from market prices of stocks of companies that are engaged in the same or similar lines of business and that are actively traded on a free and open market.
2. Sales of public or private companies. The merger and acquisition (M&A) method derives pricing multiples from transactions involving controlling interests in companies engaged in the same or similar lines of business.

Whether the comparables are public or private transactions, valuation professionals can select from a varied menu of pricing multiples. Common multiples compare the selling price to:

• Revenue,
• Gross profits (revenues – cost of sales),
• Earnings,
• Earnings before taxes,
• Earnings before interest expense, taxes, depreciation and amortization (EBITDA),
• Sellers’ discretionary income (with varying definitions),
• Operating cash flow, and
• Net free cash flow.

Pricing multiples can even be taken from balance sheet data. For example, an expert might compute multiples based on the comparables’ book value or tangible net assets.

No cookie cutter techniques

For years, experts have been searching for the optimal pricing multiple. But, in the end, most valuation pros agree that no pricing multiple is perfect for all clients.

Some experts tend to favor the price-to-revenue multiple because it’s simple and objective. They argue that profit-based metrics (such as earnings, EBITDA and sellers’ discretionary cash flow) are inconsistently defined and subject to manipulation by the seller or the analyst.

Others advocate using the price-to-gross-profits multiple, finding that it often has the highest correlation with sales price. But price-to-gross-profits may not be the best choice when valuing a professional services firm, where individual skills are most important and materials costs are minimal.

The expert’s choice of pricing multiple typically varies based on the nature of the subject company’s operations. To illustrate, price-to-book-value may make more sense when valuing an asset-holding company or an asset-intensive business in which book values reasonably approximate current market values.

Conversely, when valuing small businesses (under $5 million in annual revenues), multiples based on discretionary income or EBITDA may be more meaningful, because they mirror small company M&A practices and generally address their desire to reduce income tax expenses. By comparison, public company investors and market analysts tend to be more sophisticated and may, instead, focus on price-to-earnings or price-to-net free cash flow.

Ultimately, valuation experts evaluate pricing multiples by considering what matters most from the perspective of hypothetical investors in the subject company. Are they most interested in revenue, cash flow, book value or some other performance metric? Regardless of the multiple that’s selected, it’s critical for the valuation report to fully explain and defend the multiple used to value the subject company.

A valuable exercise

Experts always consider the market approach when valuing a business. But they may opt to use the income or cost approach if they can’t find a strong sample of comparables. When this happens, market data can still serve as a valuable reasonableness test for the value conclusion.