The valuation of a business reflects its position in the market, its past performance and future potential. But valuing Small and Medium Enterprises (SMEs) can be challenging as each business is unique and positioned differently on the business life cycle. This article, the second in our series on SME valuation, delves deeper into the Earnings Multiple Method, the most commonly used method in the SME market, focusing on strategies that can help you enhance your business’s value.
Valuation formula
When using the earnings multiple method, a business is normally valued as follows:
Business value = earnings multiplier x normalised earnings before interest, taxes, depreciation, and amortisation (NEBITDA).
This definition of business value normally includes all things that are ordinarily required to operate the business, which can include but are not limited to ordinary operating cash, inventory, plant and equipment, employees and their entitlements and leases. It does not normally include things like finance and other debt, like leases on equipment, overdrafts and other types of finance.
How does the earnings multiple work?
The multiple is influenced by various factors, including industry benchmarks, growth potential, and perceived risks, and is sometimes referred to as a risk multiplier. It serves as a barometer of how the market views your business. It can also be understood as the inverse of a required rate of return: if you have a required rate of return of 20% per annum, then you would expect an earnings multiple of five times. If your required rate of return is 33%, then the earnings multiple would be three times.
How can you enhance your earnings multiplier?
The multiplier is key to the valuation of your business in the market and can be enhanced with strategies like:
Owner reliance
One of the key drivers of an earnings multiple is owner reliance. If the owner is solely responsible for every aspect of the business, it significantly increases the risk for a potential buyer, leading to a decrease in its value. The more an owner can do to ‘corporatise’ a business so that it can operate independently of them, the easier it is for a buyer to come in and run it without them.
Employee engagement and culture
Investing in employee development, fostering a positive work environment and maintaining high employee engagement levels can lead to higher productivity and innovation. The quality of your workforce and company culture can influence business performance and, in turn, the multiplier.
Risk management
A business with well-managed risks is more appealing to investors and buyers. Diversifying your customer base, having robust financial controls and maintaining a healthy cash flow are all ways businesses can manage their risks. SMEs that can demonstrate stability in revenue and earnings are also often rewarded with a higher multiple.
Innovation and technology
Investing in new production technologies, adopting cutting-edge software solutions or continuously improving your product or service offerings are all ways to adopt new technologies and stay innovative, which can positively impact your multiplier.
Strategic partnerships
Establishing strategic partnerships and alliances with suppliers, distributors or even complementary businesses can enhance your business’s market reach and operational efficiency. They not only improve your business operations but also signal market strength and stability.
Transparency and governance
Good governance and transparent business practices like maintaining clear, accurate and comprehensive financial records, adhering to regulatory requirements and doing business ethically not only reduce perceived risk but also enhance your business’s reputation.
Customer relationship and loyalty
A strong and loyal customer base is a valuable asset. Focusing on customer relationship management, understanding customer needs and ensuring high satisfaction levels can lead to high customer retention rates that often translate to stable revenue streams, positively impacting the multiplier.
Market positioning and brand strength
A well-positioned brand in a favourable market can command a higher multiplier. Building a strong brand requires delivering consistent quality and customer service while also focusing on marketing efforts. This builds trust and can command a premium in the market.
Industry and market trends
Staying aligned with positive industry trends and market opportunities can significantly impact your multiplier. Businesses in industries with a bright outlook or those riding on the wave of emerging trends often attract higher multiples.
Strategic expansion and diversification
Diversification reduces dependency on a single market or product and demonstrates growth potential to investors. Expanding your business operations or diversifying into new markets or products, if done successfully, can significantly impact your multiplier.
Operational excellence
Optimising processes, reducing waste and improving productivity can enhance profitability and thereby increase the multiplier. The use of technology in streamlining operations, automating repetitive tasks and improving supply chain efficiency can all prove to be crucial in developing and maintaining effective in operations.
Environmental, social, and governance (ESG) factors
Increasingly, businesses are being assessed based on their ESG performance. Sustainable business practices, social responsibility initiatives and ethical governance can enhance your brand reputation and appeal to a broader range of investors.
The journey to optimise your earnings multiple is continuous and requires a holistic approach. Each of these factors contribute to strengthening your business’s market position and appeal, thereby enhancing its valuation. They will also help to make you more profitable along the way. In the next article in this series, we will shift our focus to directly influencing the profit of your SME so that you can maximise the value of your business.
For more information on how your business could benefit from these strategies, contact your local William Buck business advisor.
Please read our other articles in the series:
Article 1: Unlocking value in SMEs: A guide to business valuation in Australia
Article 3: Strategies to help you boost the bottom line of your SMEs
