The multiplier can be used to as a measure of the number of years to recoup an investment in a business - this is true, however i am not sure this is the best description of the multiplier as it ignores the time value of money: A dollar today is not worth a dollar in 3.5 years time! I think a better and more accepted definition for the multiplier is the projection of present business value, based on present day profits. What do you think Chris?

That's very true, Jordan - thanks for pointing that out. I've made a little adjustment in the post, while hopefully maintaining clarity.

Chris

Hey Chris. Congrats on getting the blog up and running. I see its starting to populate very fast.

I think it is useful to point out that there are many different earning multiples so it is important that you are comparing apples with apples. P/E is just one; there is also Enterprise value multiples and even denominator is different depending what definition of "earnings" you use (EBIT, EBITDA, Net profit..etc).

I think your original explanation, albeit simple, is a good one and adding the "time value of money" comment probably confuses the matter more than anything. I agree with Jordan however that it needs to be emphasised that an investment decision shouldn't be based merely on how early you can recoup your investment but rather about whether the return received from such an investment is adequate to cover the opportunity cost of the money used to purchase it. The return is implied in the price paid for an acquisition, which should factor in the time value of money as well as the riskiness of the investment. So assuming the earnings remain constant, it is correct to say the earnings multiple does indicate how long it will take to recoup the investment in norminal terms. The reason why it is important here to assume earnings remain constant is that if there is high forecasted growth, recouping your nominal investment amount may occur earlier. If the there is high forecasted growth, then an investor may be prepared to accept a higher multiple.

The main point about using earnings multiples, however, is that they are good as general guide on whether the price of a business is within an appropriate range when compared with comparable businesses (typically in the same industry and operating under the same business model). However they should never be applied prescriptively as a more detailed analysis that takes into a consideration the various nuances of the business should be performed to determine the value of the business, which may produce a higher or lower multiple than other comparable businesses.

Hi Grant,

Thanks for the comment - you're definitely on the money when you say earnings multiples are useful mainly for comparing with other businesses in the same industry & business model.

Also, I agree with what you said about the time value of money and investment risk - perhaps I can cover that in a later topic if there is interest. There's only so much I can cover in 400 or so words while also keeping it easy for non-finance heads :-).

Plus small businesses tend to have low earnings multiples (PEBIT), which makes the time value of money a bit more of a moot point. However, I'm sure it's a very different story in the middle market (and upwards).

The issue around the time value of money is important to explain why you don't just acquire a business at value of the sum of its forecasted cashflows, without any discounting. But you are right that it starts to become a bit abstract from a practical stand-point. In fact, I would imagine that how fast the business is expected to grow and how risky the environment it operates in is probably more of an important consideration to a prospective purchaser in determining a business value and therefore an implied multiple. That is, the more risky it is the lower the multiple and the faster the growth expected from the business the higher the multiple. Also, as you noted it makes sense in general for the small businesses to sell at lower multiples than larger listed counterparts, given that such an investment typically represents are larger portion of a buyer's funds than a tradeable stock investment and the associated lack of liquidity of small business ownership.

Hey Chris

Congrats on the new blog.

I have a question: what are "typical" multiplier ranges for different types of businesses (e.g. prof services vs retail vs manufacturing vs ....)?

Looking forward to your answer...

Gday Will

There are reports you can buy for hundreds of dollars where they give an indication of what you can get (i.e. a range) - these are generally used by valuers. However, these figures change from year to year depending on the economy, and the industry in general. To give you an example, imagine what effect the Internet would have on offline media sales.

However, there is still hope - there's a free publication you can get from BizExchange once you've subscribed @ http://www.bizexchange.com.au/join/default.aspx.

It gives you multipliers for a few industries, however the March 2008 numbers I read may be a bit on the high side, since the economy has gone down since then.

Let me know if this helped.

Chris

Chris, in line with Will's question - would it be possible to provide on this blog a table of the multiple ranges for business sold in the various industries, perhaps separated by year/month? Even what you have seen so far in your experience would be useful. Not neglecting the fact these multiples change all the time, I think this sort of information would be particularly useful to your readers.