You often hear about the sale of a healthcare company where the buyer paid the seller a price based on a "market multiple" of something, with that purchase price (or offer) typically based on a multiple of revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), or adjusted EBITDA.
In this column, I will break down what market multiples represent.
Determining the Offer Price
Before we dive further into market multiples, it's important to acknowledge that when coming up with offers, buyers take a deep dive analysis of the past performance of a company of interest, then they estimate what synergies they bring to the table regarding the expected future performance of the company post-acquisition. Buyers typically use a discounted cash flow analysis to estimate the future value of the company. This process allows buyers to estimate the future after-tax cash flows that they’ll derive from the purchase, based on how much they pay for the company.
Converting the Offer Price to a Market Multiple
Once the buyer has an estimate of how much its willing to offer to buy a company, they convert that dollar amount into a market multiple of some performance measure of the company’s performance. For example, the buyer might convert the amount it wishes to offer into a multiple of the company’s annual revenue or adjusted EBITDA. However, seasoned buyers also look at what similar companies sold for in the past, based on the same market multiples. If there have been a number of recent merger and acquisition (M&A) transactions for similar companies where the purchase price was 5.0x to 5.5x adjusted EBITDA and 1.0x to 1.1x annual revenue, the buyer might amend its offer to fit within other recent M&A transactions.
Some buyers also look to see what larger public companies in the same sector are valued at. For example, a large publicly traded home care business might show an enterprise value of $2.13 billion, trailing 12-month revenue of $1.21 billion, and EBITDA of $128.0 million. That company would have a market multiple of 1.88x revenue or 17.82x EBITDA. Those market multiples would represent the top of the market in terms of valuations.
Most seasoned buyers have "rules of thumb" guidelines they follow for each sector, such as never making an offer in excess of 1.50x revenue or 7.0x EBITDA for a home care business unless there’s something very special about the target company. Other buyers might have a rule that they get fully paid back from the cash flow of the acquired company in five years or less.
There’s something to remember when looking at multiples of cash flow or EBITDA: The inverse of the multiple is an approximation of the buyer’s return on investment. So, a 5.0x multiple is equal to a 20.0% return on investment (i.e., 1 ÷ 5 = .20 or 20.0%). Similarly, a 7.0x multiple purchase price would provide the buyer with an approximate return on investment (ROI) of 14.28%. Most buyers are seeking +20.0% ROI on M&A transactions. As such, if a buyer makes an offer of 7.0x cash flow or EBITDA, it is expecting future cash flow or EBITDA to grow to fulfill the desire for a +20.0% ROI.
Income Taxes
Earlier I mentioned that buyers usually undertake a discounted cash flow analysis using after-tax cash flow or EBITDA to estimate the value of a target company. You might find it strange that they use after-tax dollars in their analysis even though many companies do not pay taxes. The reality is that income taxes must be paid by someone. If it’s not paid by the company, it’s paid by the owners of the company. Buyers want to determine their cash ROI after taxes.
Different Purchase Structures
Buyers can take advantage of structured purchases to offer a higher multiple and still retain their desired ROI. A seller note is a typical method of structuring a purchase where the future cash flows of the acquired company are used to pay a portion of the purchase pricing. A buyer may offer a 6.0x multiple of EBITDA purchase price but pay a 4.0x multiple of EBITDA at closing followed by a five-year seller note equal to a 2.0x multiple of EBITDA.
Similarly, the buyer may offer the seller an earnout based on the future performance of the acquired company. A buyer may offer a 6.0x with 4.0x at closing followed by a percentage of future EBITDA not to exceed 2.0x of the closing EBITDA.
Understanding Market Multiples
The concept of market multiples is a way of communicating value between buyers and sellers. A seller doesn’t sell based on multiples but rather based on real dollars. The same holds true for buyers. Buyers undertake great effort to estimate the value of target companies, specifically to them.