How many times profit is a business worth?
Businesses that are valued on the basis of a multiple of their profit (or Earnings Before Interest and Tax) are being valued using the Capitalisation of Future Maintainable Earnings valuation methodology. This method places a value on a business by estimating the likely Future Maintainable Earnings (FME), capitalised at an appropriate rate which reflects business outlook, business risk, investor expectations, future growth prospects and other entity specific factors. This approach relies on the availability and analysis of comparable market data.
The FME used in the valuation can be based on net profit after tax or alternatives to this such as EBIT or EBITDA. EBIT multiples can range from 0.8 times FME to over 5 times, depending upon the industry, performance, and relative risk of the subject business. However, for businesses that turn over less than $5 million per annum, around 80% of them that sell, do so for less than 3 times the EBIT (or profit), whilst businesses that turn over less than $1 million are lucky to sell for 2 times EBIT. Once businesses start turning over more than $5 million, they are more likely to reach multiples in excess of 3 times. To sell for more than that, the business needs to be doing something pretty remarkable to set itself apart from its competitors.
Of course, some industries see higher and lower profit multiples and there will always be businesses that were sold at a bargain-basement price, whilst others were sold at a premium. When determining a multiple, it is important to remember what it represents: RISK. The higher the multiple the less risk that the business will continue to earn the profit level being multiplied. The lower the multiple, the riskier it is that the business will not maintain that level of profit.