A while back a prospective buyer suggested that a business I was representing was overpriced. His reason? Another broker provided him with data on a variety of sold comparable businesses that supported his contention that businesses in that industry sell for 10-12x monthly revenue.
Here’s the problem with this: revenue usually has little to do with what a business should be worth. Rather, cash flow is what creates value. Let me explain why:
Consider an average business in that industry had $5 million in revenue and sold for $4,166,667. Given that the average EBITDA margins for the industry are 10%, let's assume that the business had $500,000 in EBITDA. The price would be consistent with the other broker's belief that businesses in that industry sell for 10x MONTHLY revenue ($5 million / 12 months X 10 months). The $500,000 in EBITDA would represent a 12% EBITDA return on investment in the first year.
But what if another business in the industry also had $500,000 in EBITDA, but was more efficiently operated and, as a result, its EBITDA margins, at 25%, were far higher than average? Such a business would only have $2 million in annual revenue. If you used the formula of 10x monthly revenue for value, it would suggest a value of only $1,666,667. The $500,000 in EBITDA would represent a 30% EBITDA return on investment in the first year.
Since the industry average EBITDA return on investment is 12%, why would a buyer expect to achieve a much higher 30% EBITDA return on investment for a company that is better operated and thus more profitable? Logically, the company with the higher margins should be valued higher, all other things being equal, not lower than the poorer performing comparable business.
A better way of comparing businesses is to look at a multiple of EBITDA (after paying an owner/manager a market rate of compensation). In the example above, the sold comparable business that had $500,000 in EBITDA, 10% EBITDA margins, annual revenue of $5 million, and a price of $4,166,667 would have sold for 8.33x EBITDA. If you apply that same EBITDA multiplier to the latter business which also had $500,000 in EBITDA, but with the much higher 25% EBITDA margins and annual revenue of $2 million, it would result in the same value of $4,166,667. This would mean that the EBITDA return on investment for the business with higher margins would be consistent with the comparable sold business: both would have EBITDA returns on investment of approximately 12% in the first year.