This Port of Call introduces the concept of Implied Value that results from a simple equation based upon two variables, EBITDA and the Multiple.
The resulting equation is:
Implied Firm Value = Firm EBITDA x Multiple
This formula seems simple and straight forward, but the application of the equation may not be so intuitive.
EBITDA is a financial metric derived from the income statement and represents the firm’s cash flow. Notwithstanding market and economic conditions, EBITDA is dependent on management’s ability to generate profit.
While EBITDA is dependent on profit, multiples are dependent on a potential investor’s Cost of Capital. It is important to understand that management can directly affect EBITDA growth but can only impact the Multiple by making the firm attractive to investors by reducing the perception of risk. Risk increases investors’ Cost of Capital thereby reducing the Multiple.
Studies demonstrate that investors’ Cost of Capital, as represented by the range of Multiples, generally fall within a range of 4 to 7. This implies that investors’ cost of capital ranges from about 25% to 14%. Multiples outside of this range appear to not be entirely based on cash flow. One of the best multiple studies comes from the “Private Capital Markets Report” published by the Pepperdine University Graziadio Business School that puts the range of multiples across industries and sizes in the range of 4 to 7 X EBITDA[1].
This is not a mystery as the Cost of Capital, as previously discussed, effectively limits what the rational magnitude the multiple can be by a potential purchase’s opportunity cost. A purchaser’s Cost of Capital and, thus, its opportunity cost, is the reciprocal of the multiple.
Owners can influence multiples by reducing risk. However, cash flow (EBITDA) is the main driver of firm value.
[1] Everett, Craig R.,”2021 Private Capital Markets Report” (2021). Pepperdine Graziadio Business School.
*http://digitalcommons.pepperdine.edu/gsbm_pcm_pcmr/14. Also See, “2023 Private Capital Markets Report”,
* http://digitalcommons.pepperdine.edu/gsbm_pcm_pcmr/16
Owners must focus on increasing cash flow rather than achieving a high multiple to increase value as a going concern.