I’m talking about the valuation multiple on the company you think you’d like to acquire.
Several months back I was talking the owner of a company, one of my client’s acquisition targets, about valuation. The conversation was similar to one I’ve had many times. He felt that his company was worth 7x trailing twelve months operating income, or based on my best estimate, about 5.6x EBITDA which is on the high side for an industry that is seeing similar transactions in the range of 4-5x EBITDA. His rational was that the company, at about $15 million in revenue, was achieving 20% operating margins–he suggested that I go try to make that kind of profit in the stock market. He also indicated that there had been offers in the past that were south of 7x operating income, and he felt he could do better.
Again, this is not an uncommon perspective for business owners and talking someone away from their anchored position on value can often be difficult, if not futile. Assuming my client is interested in the target, which would be a platform acquisition (almost no consolidation synergies), I ask myself, “What kind of growth would my client have to achieve over the coming years to meet their expected return at a purchase price of 7x operating income?” In general, I like using the multiple-of-earnings approach to value businesses; they are simple and clean, and many middle-market-acquirers rely heavily, if not solely upon earnings multiples to value their acquisitions. But sometimes it helps to look at valuation from a different perspective to get a sense for what that multiple really means in terms of performance metrics required of the business.
I’m attaching a simple back-of-the-envelope discounted cash flow model that I like to use to sanity-check EBITDA based valuations. Following the discussion mentioned above, I used available financial information and made some educated guesses on the rest. This business is a manufacturing and repair business, so the assumptions around capital expenditures, depreciation, and net working capital are consistent with my experience in this space. I’ve included a picture of the excel model below. Click on the picture to see an enlarged view.
I won’t get into the nitty gritty details, but this shows that in order to achieve a 15% internal rate of return, I have to hit the ball out of the park over the next 5 years with a 13% growth rate and, after year 5, a perpetual growth rate of 5% (many times better than the current economy). That’s a tall order for a new platform to achieve virtually on its own.
As a counter balance to this analysis, there are always other major strategic considerations. This particular target may have some unique assets, capabilities and customer relationships that my client needs to take into account. Their strategy may be to acquire this business, which operates in a fractured industry, and then use it as the anchor to make other sector acquisitions at lower multiples where they can realize synergies. This napkin discounted cash flow model is not meant to provide a basis for “go or no-go,” and I’d like to add the caveat that this is not a professional valuation model and the results do not represent the advice or opinions of Third Coast Capital Advisors. Now that I’ve gotten that out of the way, if you are interested in the excel model, just reply to the blog and I’ll send it to you. Happy valuing.