01 Dec The Pitfalls of Price to Revenue Multiples
The price to revenue multiple (also referred to as the revenue multiple or sales multiple) is often used by small business professionals to estimate the value of a business, because of its simplicity. It’s a ratio calculated by dividing the value (price) of a company by its annual revenue. Certain businesses such as accounting firms (1.0-1.2x revenue), dental practices (0.65-0.7x revenue) and insurance agencies (1.5-2.0x revenue) have widely agreed upon revenue multiples. However, caution must be exercised when relying on a revenue multiple to determine the value of a business, as it can result in a value that might not be supported by the cash flow of the business. The revenue multiples are only accurate when the expense structure of the business is in line with its industry standards.
As an example, Table 1 below depicts an income statement for a general dentistry practice. The practice is run efficiently and is achieving a 35% Seller’s Discretionary Earnings (SDE) profit margin, which is in line with the industry average for a general dentistry practice.
Typically, dental practices will trade at 2 times SDE or 0.70 times revenue, which result in the following values for the business depicted in Table 1:
As seen above, the two approaches result in the same value, primarily because the expense structure of the business is in line with the industry. However, this is not always the case. What happens when the business is mismanaged and has higher than average expenses, resulting in an SDE margin that is lower than the industry average? Table 2 below depicts such a dental practice, with higher Staff Compensation and Clinical Supplies expenses:
The Staff Compensation expense is 6% higher than the industry average, while the Clinical Supplies expense is 4% higher than the industry average. This results in an SDE profit margin that is 10% lower than the industry average. Now, let’s estimate the value of this business using the same 2 times SDE and 0.70 times revenue multiples:
The SDE multiple indicates a lower value, while the revenue multiple indicates the exact same value as the first practice, despite having $100,000 less in earnings. All else being equal, it is clear that the practice with higher earnings (that is being run more efficiently) is worth more to a hypothetical buyer.
The above examples illustrate the dangers of relying exclusively on revenue multiples to calculate the value of a business. Although revenue multiples may be the quickest way to gauge a rule of thumb range of values for a business, they should not be solely relied upon to determine the value, as small business owners are primarily concerned with the earnings potential of a business and their return on investment.