If you are looking at a business that has had strong growth for the last 3-4 years should you base valuation calculations on the most recent 12 months, a 2-year average, 3-year average, or something else? While this depends on many factors including the unique characteristics of the business, stability of the growth, and the valuation techniques you are using, I’d like to point out why using the most recent 12 months may be more accurate than using a 2-3 year average if you are using a market comparable approach to value:
1. If you are using a market comparable multiplier to value the business, most of the sold business comparable databases develop the revenue, EBITDA, and seller discretionary earnings multipliers using the most recent 12 month financial data before the sale. In fact, most of the sold business comparable databases don’t have more than the past year’s financials. While a very small percentage of small businesses that sell are distressed, the vast majority are businesses that have seen a history of increasing earnings. If they have not exhibited growth than most business owners find it very difficult to attract the interest of buyers, and they won’t sell and thus won’t be included in a sold comparable database. Consequently, if someone is using a multiplier based on the most recent 12 months financials for growing businesses, and applies that to a business being valued using more than the most recent 12-month numbers it will be an apples-to-oranges comparison. For example, assume that for a particular type of business the average Seller Cash Flow was $200,000 and the average Seller Cash Flow multiplier was 2.75, for an average value of $550,000. If those comparable businesses had grown an average of 15% per year for each of the past three years, then their 3-year average Seller Cash Flow would actually be $175,047, and if you divided their average sold price of $550,000 by that 3-year average the Seller Cash Flow multiplier would increase to 3.14.
2. Another way to look at this would be what if Business A had a three year average EBITDA of $1 million, where three years ago it was $800,000, two years ago it was $1 million, and last year it was $1.2 million. Compare this to Business B who also had $1 million of EBITDA, but its last three years were $1.4 million three years ago, $1 million two years ago, and $600,000 last year. If the average EBITDA multiplier for similar sold businesses was 5x, and you applied it to both businesses you would deduce that each was worth $5 million. Yet, if Business A and Business B both had flat growth in the coming year then Business A would produce a return on investment of 24% whereas Business B would only produce a return on investment of 12% – which would be odd given that Business B is a declining business and should warrant a higher return on investment to compensate for greater risk. Also, if the risk factors that were inherent in the business and industry indicated that a price that produced a 20% EBITDA return was appropriate, then with flat growth Business A should have commanded a price of $6 million. If Business A continued to grow consistent with past performance, then next year its EBITDA would grow to $1.4 million, and if using a 3-year historical average it would under-value the business by $2 million.
3. The problem with the scenario described in my second point is that the person valuing the business has already modeled the risk into their projections for a growing business. In essence, if a business has grown from $800,000 in EBITDA three years ago, to $1.2 million today, but a $1 million average is utilized for calculating value, the person valuing the business is assuming a decline in EBITDA of $200,000 from the most recent year. If someone wants to model that risk, that’s fine, but that means that a higher multiplier must be used to take into consideration that the risk of decline has already been modeled.