What Really Drives Multiples
When I was an executive at two entrepreneurial ventures, I remember being fascinated by valuations—how were companies with similar business models being valued, how were companies within our industry being valued and how were valuations trending at any given time—and where the valuation for our companies would be. My fascination usually defaulted to the prevailing wisdom (or, more accurately, the urban legend) at the time of the appropriate “multiple” to use and whether it was a multiple of revenue or EBITDA. My thoughts on valuation usually began and ended with the exercise of multiplying a multiple by something and, more often than not, applying some very high multiple that passed through the particular industry grapevine like wildfire.
Since I have been at Harbor View, I have noticed that my former approach to valuations is typical. Entrepreneurs are as fascinated with multiples as I was and are usually not thinking about the underlying fundamentals that drive those multiples in the first place. Rarely do valuation conversations occur that discuss a discounted cash flow model and the elements that comprise it. Why? Because that analysis takes more work and multiples are easier since they provide the “shortcut” to the answer.
A further weakness of my previous thinking is that I always believed that my companies would trade at or above the highest multiple that I had heard at any particular time. I call it a weakness because all I had was the multiple itself (which could have been real or inflated) and not the underlying reason/fundamentals for doing the deal in the first place (did the acquired company have an exponential growth rate and potential, did it have unique and compelling intellectual property, did it have some sustainable unfair competitive advantage within its market). Simply applying my chosen multiple to my chosen factor wasn’t complete.
As we have engaged with our clients at Harbor View over the years, we have worked hard to demystify valuations for them by re-centering their expectations of valuations around the fundamentals in two important ways.
1. Discounted Cash Flow Models Matter
Regardless of the multiple that resulted and/or was used, acquirers leverage the discipline of discounted cash flow models in determining or supporting a negotiated amount. Yes, buyers may negotiate a value for a target with an “outsized multiple,” but they have either built their discounted cash flow model prior to making the offer or they have built it after the offer in support of it. They have done their work and they very rarely make an acquisition without doing so. Therefore, you shouldn’t ignore the role that DCFs play in the acquisition process because they underlie the “shortcut” of a multiple.
2. Fundamentals Drive Value
Second, the underlying fundamentals of the acquired business have an impact on whether that business receives a benchmark, premium or discounted valuation. Are you growing at 100% year-over-year or have you been flat? Is your customer base concentrated in one or two customers or is it dispersed? If you are a technology company, is your platform install based or multi-tenant? Do you have a recurring revenue model or is it transactional in nature? Do you have a sustainable unfair competitive advantage or are you one of many providers of a similar offering? The answers to these and other questions will determine whether your valuation will be at, above or below the benchmark.
Key Valuation Drivers
What is a discounted cash flow model and what are the fundamentals? Stated very simply, a discounted cash flow model allows a buyer to assess an investment’s risk versus its reward by projecting the estimated future cash flows of the investment and calculating the present value of such future cash flows. It is driven by the “rewards” of the future cash flow that are discounted back to present value through the “risks” associated with attaining those future cash flows. It assesses a target’s (a) ability to grow, (b) ability to handle growth and (c) ability to predict growth.
Discounted Cash Flow Models: Understanding Valuation
If you are in a large market with very few competitors and you have a robust sales and marketing engine, then you should have an outsized ability to grow and your “rewards” should be greater. However, if your model is transactional in nature (rather than recurring), you have one customer that accounts for over half of your revenue and your technology is installed rather than multi-tenant, then the “risks” associated with attaining the rewards are higher, which will impact the discount rate used and, ultimately, lead to a lower valuation of your company. Essentially, a buyer will view your ability to handle growth and your ability to predict growth as riskier.
In the next three articles, we will discuss in more depth the concepts of ability to grow, ability to handle growth and ability to predict growth and how they affect the valuation of a business. For now, simply note that there are always fundamental reasons for valuations, particularly those that are considered outsized. So the next time the industry grapevine delivers word of a 10x revenue multiple of a business in your space, take the time to consider that there were fundamental reasons driving that valuation.
DISCLAIMER This presentation is intended for information and discussion purposes only and does not constitute legal or professional investment advice. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of Harbor View Advisors, LLC (“HVA”). The information in this presentation was compiled from sources believed to be reliable for informational purposes only. HVA does not endorse or approve, and assumes no responsibility for, the content, accuracy or completeness of the information presented.