Thousands of Lemmings Can’t Be Wrong!!!
As many of you long time readers (sufferers) of my M&A blog already know, I am not a believer in thumbnail calculations for the valuation of businesses. No matter which sector or which industry, the majority of the time the valuation multiples that are bandied about, range between 5 to 7 times EBITDA. The idea that a business will typically be sold for a value that is 5 to 7 times its EBITDA figure is utterly impracticable. I understand why this figure is cited and, for some, it does serve a purpose. However, for the buyer or the seller I believe it offers no real value and should be totally disregarded.
There are four main reasons why the X EBITDA is little more than a worthless myth and why it has become so prevalent:
1. The “average” calculation: A simple scan through our entire listing of all the deals concluded in this sector quickly reveals that a huge variety of EBITDA and revenue multiples has been achieved. Yes, it is possible to create some statistical averages but then again, we can create an average for anything. The question is, does it work as a useful guide and predictor for your business? For example, if I was to calculate the average size of all living human beings, including children, then my average may well be 4ft 8inches (142cm) - Not really a good guide if I use it to predict the height of the next person I am likely to meet in business. Not sure why I would want to do such a calculation but hopefully it makes my point : ))
2. Investors Guide Rule: Although they may not wish to be thought of this way, investors are, in fact, educated gamblers; they play a numbers game. They buy a number of businesses at say, X5 EBITDA, build them and then sell them at X7 EBITDA. They do plenty of deals like this and then one or two sell at a much bigger multiple; they make their money, their investors are happy and the partners go home rich. Although most investors work across quite a wide range of sectors, they always have some sort of presentation which indicates that they have a sector bias. However, it is usually very broad and, as such, they are not able to have really in-depth knowledge, except maybe just enough to play the numbers and make some money. They know enough because it works!
3. The Acceptable “Fit” after the fact: The other reason that that the multiple times EBITDA and revenue is still so prevalent is that very often when a company acquires they want it to look as if they have just paid “Standard Multiples”. Once the EBITDA figure has been “normalised” it is then interesting to see how often the “normalised” range of multiples is also met.
4. Innovation: There are many examples of the smaller, faster moving companies that have been able to innovate, bringing great value to larger businesses via acquisition. (http://www.documentboss.com/blog/innovation-your-security-success) In fact, a number of studies have shown that acquisition is often the best way for the larger, slower moving companies to innovate rather than throwing a lot of money at R&D. Smaller businesses have traditionally been very good at using their limited R&D funds to create some innovative changes in the IT sector. Many of these companies are not highly profitable. In fact, many can be loss making but, once successfully integrated under the umbrella of a bigger company with funds and sales / marketing leverage and expertise, these types of acquisitions can show a rapid and significant ROI.
One last Myth to dispel
And finally, whilst I’m on the subject of myths, were you aware that lemmings do not commit mass suicide? A Walt Disney movie, released in 1958, showed what appeared to be evidence of lemmings throwing themselves off a cliff in some form of self-culling, suicide pact. The reality was that the film makers bought the lemmings from Inuit school children and then herded them over a cliff to make the film look more dramatic. See http://m.youtube.com/watch?v=xMZlr5Gf9yY
