Martinka Consulting's Getting the Deal Done Podcast
Informative insights and conversations with owners, CEOs, M&A dealmakers, and other professionals on lessons learned, tips, current business conditions, and more.
Welcome. This is John Martinka and the Getting the Deal Done podcast. Today we are going to talk about multiples, as in multiples of earnings or in what your return on investment is on any kind of investment, but especially when buying a small to lower middle market business. So I'm asked all the time, what do you think the multiple is on this business? Or someone will say, Oh, I'd pay four X for that company. And I always say, I don't know. And how do you know? Because it's more than just pulling a multiple out of the air. The multiple is your return on investment. A four multiples 25%. A five is 20. A 7 is about 14%. That's the rate of return you would get. And in my world, based on history, they are a lot like the price-earnings ratio of publicly traded stocks. Although the big difference is publicly traded stocks have a lot of this is what I expect the company to do rather than this is what the company has done. For example, major banks, Chase, Bank of America, BEMO, all around 13 the day I record this. A utility company, I have some stock in. It's about 15. Starbucks, 22. Microsoft, 37. Amazon, 52. Now, if you round that to 50, that's a 2% rate of return. People aren't expecting 2%. They're expecting the stock to go up and make it a lot more valuable. But let's go back to pulling a multiple out of the air. They're based on things like is there customer concentration or not? Or are two companies look the same, similar industry, similar size? One's been growing at 10% a year, one's been declining. Would you give them the same multiple? No, of course not. And then we run into a multiple of what? EBITA, earnings before interest, taxes, depreciation, and amortization is the most common term used. Is it valid? Well, it can be, but not if your company has a lot of capital expenditures on a regular basis. The example I like to use is vehicles. You've got a company with a lot of vehicles. And let's just use round numbers. There's 25 of them, and they have a five-year life. And that means you're replacing five vehicles a year. If those vehicles cost $75,000, that's $375,000 every year. That's cash out, whether it's out of the bank business's bank account or paying off a loan. It is cash out. You could use net operating income, but that really is incomplete when you look at the overall picture of a company. Free cash flow is the one I like. And I I use EBIDA. And then I do a double entry. I subtract out the owner's comp and add back in the fair market owner's comp. And since we're already allowing for depreciation, we will look at what are the anticipated capital expenditures. That pretty much gives you your return on investment. And it is a heck of a lot better than one term I really don't like at all: seller's discretionary earnings, which I think was quasi fraudulent. They are saying, well, the salary, the medical benefits, etc., etc., really isn't a necessary expense to the owner or income need to the owner. They don't have to take a salary. Last I checked, banks always put in a salary for whomever is running the company, owner or hired help. Appraisers, legitimate appraisers, do the same thing. So we we are calculating a cash flow, and then we are multiplying it. We are looking at a return on investment. And I'm going back in time a few years, and it was the week of the 4th of July. Wasn't much going on. I got a call from an attorney who said, Can you help me out with a quick report? He had a consumer fraud case. And as I understand it, company was making about $5 million a year, had all these claims that the court had upheld. And they sold the company for hundreds of thousands of dollars to someone internally, not an isolated transaction. I wasn't to help on that. I was to give him a report on what would a company doing, making $5 million a year typically sell for? And what would a company that sold for, I think it was $350,000 have in earnings to justify that price. So I did the report, got it off to him, and then I started playing with the numbers. I looked in the databases that we have on done deals. I got some more information from an uh investment banking friend, and I came to the conclusion, no matter how I twisted and manipulated the input and the size range of deals where you're selling to an individual buyer, the multiple is four with a coefficient of variance of a little over 25%, meaning about three to five times earnings free cash flow. For larger businesses, as you get into the private equity world, that three to five turns into five, six, up to nine, at least at that time. And sometimes it's a lot higher, depending on how motivated the buyer is. And there are fewer sanity checks on those larger deals than on smaller deals where it's an individual. When it's an individual buying the business, the two sanity checks are it's their money, and they're not going to be writing a bigger check just to get a company like a private equity firm might do. And then the bank, the bank is a big sanity check. And all this comes down to what's the multiple, but then it's what do you do with it? A private equity friend told me, he said, look, if we pay 4x and it grows, it doesn't grow like we want it to, it's a bad deal. If we pay 7x and it grows, it's a great deal. Because to them, it's not about just the uh the multiple, it's about what they do with it. And you should keep that in mind. That doesn't mean go crazy on multiples and pricing, but realize and understand where they really come from, and it's not thin air. Thank you for listening.
