A multiple of earnings is a valuation method whereby the value of a company is expressed through the use of a multiple applied to the Company's earnings. For instance, a company that has Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) of $2,000,000, that has a "value" of $10,000,000, was valued at 5 x EBITDA. The appropriate earnings multiple that should be used to value any particular company depends upon a number of factors, or attributes. One way to drive a higher value for your company is for it to possess some of those attributes that warrant a higher earnings multiple. Predictability of revenue, sometimes referred to as "stickiness" of revenue, is one of those attributes that impacts the earnings multiple.
Companies with highly predictable or recurring revenue streams sell for much higher multiples than companies whose revenue is not recurring, or is dependent upon constantly generating transactions with new customers for its revenue stream.
Some of the factors that demonstrate a higher level of predictability of revenue include:
- Contractual agreements with customers for repetitive sales of goods or services, such as manufacturing companies with long term purchase orders, or service companies that have annual recurring service contracts.
- Operating in an industry where the barriers to entry are high.
- A solid and growing customer base with very little turnover.
- Serving a market, either industrial or geographic, that is growing.
- In the case of distribution companies, protected territories or exclusive rights to product lines.
- A revenue model that resembles a razor/ razor blade concept - where customers are "locked in" to a company's product or services.
Factors that indicate revenue is not highly predictable include:
- The majority of the customer relationships are managed by the owner of the business, or a small group of sales executives (the risk being that if the owner is no longer involved, or if the sales executives leave, the customer base may no longer have loyalty to the company).
- The barriers to entry are low - new competitors can easily enter the market, thus increasing the competitive landscape.
- Revenue is project dependent.
- There are pricing risks, either from changing technology or governmental regulation.
There are many other factors that come into play, way too many to outline in this article. As a business owner, we recommend that you review the sources of revenue for your company and, if possible, take steps to improve the "stickiness" of your company's revenue stream.
In future articles, we will discuss other factors that impact a company's earnings multiple, such as strength and depth of the management team, the company's operating systems, reliability of the financial reporting system, opportunities for growth, the make-up of the customer base, intangible assets, strength of cash flow, scaleability, the amount of capital investment required to sustain or grow a business and preparedness for the due diligence process.
If you have any questions or would like to discuss your particular company and how you can improve your valuation multiple, contact us, we would be happy to share our knowledge with you.