Pricing multiples are useful metrics to standardize the price of M&A transactions involving companies with different characteristics within the same industry or market segment. Like most descriptive statistics, they enhance our understanding of the underlying trends in a given dataset, and in the case of M&A transactions, pricing multiples help us get a better sense of current or emergent market conditions. There is, however, more than what meets the eye regarding M&A pricing multiples and understanding these subtleties can make the difference between a successful and an unsuccessful transaction.
It is important to note that in every apparently simple revenue or EBITDA pricing multiple there are several embedded drivers that are not so readily apparent. Understanding how each of these factors affects the resulting pricing multiple can be very useful in crafting a successful M&A negotiation strategy.
The Triad. Pricing multiples are mainly influenced by three factors: risk, growth, and leverage. When it comes to M&A transactions, the future cash flow of the target company – along with the associated synergies – strongly influence how much a buyer would be willing to pay. Hence, smaller companies are usually perceived as riskier than larger, more established companies. As a result, the buyer is usually inclined to pay a lower price. One can think of the resulting EBITDA multiple paid by a buyer as the number of years it would take for the buyer to recuperate the investment on a pre-tax basis assuming that cash flows remain flat during this period. In this sense, company size serves as a proxy for risk and is directly related to the magnitude of the resulting pricing multiple. Similarly, the faster the growth in cash flows, the sooner the buyer would recuperate the investment. As a result, holding all other variables equal, a buyer would be more inclined to pay a higher multiple for a company whose cash flows are growing at a faster rate since a higher return would be realized in a given time period. Lastly, the higher the leverage used by a buyer in a transaction, the higher the multiple they can afford to pay and still achieve their expected return on equity (assuming, of course, that the return on investment is higher than the cost of debt). Incidentally, each of these effects can, and should, be isolated and calculated to have a better idea of their influence on the final transaction price and thus be able to plan a more effective negotiation strategy.
You Get What You Pay For. The numerator is what you pay; the denominator is what you get. In standardizing transaction prices, the numerator reflects some measure of market value (the price paid), whether that involves the market value of equity, the market of value of the firm’s total assets or the market value of the firm’s operating assets (a.k.a. enterprise value). The denominator, on the other hand, reflects what the buyer is getting, namely, revenues (or revenue drivers such as number of subscribers, units, etc.), earnings, cash flows or the book value of the firm’s equity, total assets or operating assets. A key aspect of this process is to be consistent with how the multiple is defined. In other words, if the numerator involves the market value of equity, the denominator must be an equity metric such as net income or book value of equity. Likewise, if the numerator involves the market value of the firm’s operating assets (enterprise value), the denominator must reflect an associated firm-wide (invested capital) metric such as revenues or EBITDA. Inconsistencies related to how the pricing multiple is calculated in terms of mismatches between the numerator and the denominator will lead inevitably to conclusions not supported by fundamentals.
Comparability is key. For a pricing multiple to be relevant, it is important that the underlying companies used to calculate the multiple are “comparable” to the subject company. Unfortunately, for most private companies the transaction details are simply not reported or incomplete. This complicates determining whether a pricing multiple is a suitable reference for a target company. Thus, there are two recommendations to keep in mind. First, make sure that the companies included in the dataset are “as similar as possible” to the target company both operationally (size, growth, profitability) and financially (leverage). Also, keep in mind that perfect matches are highly improbable and that the information most often will be incomplete. Second, given the lack of transparency in the underlying data, the resulting range of pricing multiples should be used only as a general guideline and should not be considered a driver in pricing an M&A transaction.
Multiples are the results of transactions, not their drivers. Using pricing multiples to determine the likely price at which a transaction should close often leads to the wrong expectations and will likely jeopardize a transaction’s outcome. The common practice of using multiples as deal drivers represents a perilous shortcut that circumvents the process of examining a company’s fundamentals and almost always results in sub-optimal outcomes.
The bottom line. There are many different levers influencing pricing multiples in M&A transactions and most of them are not readily apparent. Therefore, in developing and executing an M&A negotiation strategy, take time to do the analysis to understand how each of these levers affects the pricing of the target company and use pricing multiples just as general guidelines to get your bearings on the market. Ultimately, each transaction should stand on its own merits and be negotiated accordingly.
About the Autor
Enrique C. Brito, MBA, CFA, CVA, CM&AA is a managing director of Kaizen Consulting Group, an M&A advisory firm headquartered in Richmond, VA providing merger and acquisition, capital formation and business strategy services. He has over 25 years of corporate finance and investment banking experience and lectures nationally on the subjects of M&A, business valuation and negotiation.
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