EBITDA and the Multiple

In the September/October issue, I defined EBITDA as net profit adjusted to make it more useful for business valuation. To estimate a company’s value, valuers multiply EBITDA by a number called the “multiple.” The result is the estimated value of the company. For example, a company with an annual EBITDA of $500,000 and a multiple of 2 has a value of $1 million.

$500,000 EBITDA × 2 multiple = $1 million valuation. 

Can you change the valuation? Yes, and knowing how is key to maximizing your company’s value. The first step is understanding the impact of changing one or both numbers.

Impact of doubling EBITDA or the multiple

Doubling EBITDA or the multiple doubles the company’s valuation.

• Double EBITDA: Increasing EBITDA from $500,000 to $1 million with a multiple of 2 results in a $2 million valuation.
• Double the multiple: Increasing the multiple from 2 to 4 with an EBITDA of $500,000 also results in a $2 million valuation.

What if you could double or even triple both numbers?

• Double both: Increasing EBITDA to $1 million and the multiple to 4 results in a 400% increase to $4 million. 
• Triple both: Increasing EBITDA to $1.5 million and the multiple to 6 results in a 900% increase to $9 million.

These compound increases seem extraordinary, but they are not. Professional investors and private equity groups routinely buy businesses at lower EBITDAs and multiples with the intent of achieving exponential results. They reap the benefits when they sell the businesses in the future. 

Increase EBITDA 

Improving EBITDA means increasing your net profit. Instead of revisiting every profit-increasing tactic, focus on applying a valuation mindset. 

Every income and expense decision should be viewed through a valuation lens. For instance, consider a potential $10,000 savings that involves tough decisions. You’ve postponed the decision to avoid conflict, and besides — it’s “only” $10,000. However, that wasted expense reduces your EBITDA by $10,000 which, at a 6 multiple, is $60,000 in lost valuation.

Increase the multiple

Unlike EBITDA, the multiple is largely subjective and is based on the buyer’s perception of risk. Future profits are the return on a buyer’s investment and the buyer’s risk is that future profits will decline or disappear. The lower the perceived risk, the higher the multiple.  

To improve the multiple, inspire confidence. We do this by providing evidence that our companies are run professionally and will continue to generate the same or growing profit.  

Here are key areas to focus on:

• Proper accounting and bookkeeping: Ensure you have three years of professionally prepared financial statements that reconcile with tax returns. Good books demonstrate competent management and reduce buyer uncertainty.
• Manage customer concentration: High customer concentration occurs when a large percentage of sales come from a few key customers. This increases risk since losing a key customer could significantly affect profitability. Diversify your customer base by targeting new market segments.
• Build a strong management team: If your business relies heavily on you or lacks a solid management team, buyers perceive this as a risk. Invest in leadership development, delegate and create a succession plan.
• System dependence: Businesses can be primarily system-run or people-run. We all need both, but companies heavily people-run are riskier than system-run because people can leave at any time. Document your processes, implement standardized procedures and use technology to support your operations.
• Strong profitability: View your profits through a valuation lens. For example, a $1 increase in profit, depending on the multiple, could increase your company’s valuation by $2, $4 or even $6. 
• Great marketing: Develop a strong brand and effective marketing campaigns. Consistent, systemized marketing inspires buyer confidence. 
• Legal and compliance: Buyers are cautious about potential legal risks, so address any outstanding compliance matters and maintain a clean legal record.
• Growth potential: Demonstrate the potential for future growth. Develop a strategic growth plan, showcase your market potential and highlight any competitive advantages.

Maximizing value

Here are practical steps to maximize your business value:

• Regularly review financial performance: Monitor your profitability and use reports to make informed decisions and track progress.
• Learn to delegate: Ask yourself, “Who else could do this?” 
• Enhance operational efficiency: Improve your operational processes to reduce costs and increase productivity.
• Build a strong brand: A recognizable brand that resonates with your target market can attract more buyers.
• Seek professional advice: Financial advisers, business consultants and valuation experts can help you navigate complex valuation issues and develop strategies.
• Prepare for due diligence: Ensure that all aspects of your business — financial records, legal documents and operational procedures — are well-documented and organized.
• Communicate your value proposition: Clearly articulate your competitive advantages, growth potential and any unique selling points.
• Plan for the future: A long-term plan demonstrates your commitment to the business and its success.

Final thoughts

Understanding and effectively managing both EBITDA and the multiple are crucial for maximizing your company’s value. By strategically increasing EBITDA through improved profitability and enhancing the multiple by reducing risk perceptions and showcasing growth potential, business owners can substantially increase their business’s valuation over time. Remember, this process requires commitment, strategic planning and a mindset geared toward long-term value creation.