What Happens to Valuation Multiples During Economic Shifts?

One of the most common topics people want to discuss with us is the idea that valuation multiples are a on a roller coaster ride alongside the economy.  Most people understand the value of a business is its annual adjusted profit times a certain multiplier.  That multiplier is based on past sales of similar businesses and on characteristics of that business such as infrastructure and customer concentration. But, while it’s true the value of a business can rise and fall through economic cycles, it’s rarely due to a change in multiples. In fact, valuation multiples remain relatively static over time.

Here’s what’s really going on:

• The economy impacts businesses, not multiples: The economy could tank, and a business could follow.  Their top line revenue would drop, and so too would the bottom-line profits.  When you look at the basic valuation equation (Adjusted Net Profit x Multiplier = Business Value) it’s easy to see how a drop in profits impacts the value.  For example, any number times 3 will be greater than a lesser number times 3. 
• Emotions can shift multiples: There are rare instances where multiples shift, but this has more to do with emotions.  A well informed and represented seller and a well informed and represented buyer will come to a fair and market-based price when negotiating a business sale by utilizing standard multiples.  But, there are times where the motivation of a buyer or seller, influenced by outside factors, can shift multiples beyond industry norms. 
• You get what you pay for: Businesses are valued based on their bottom line.  There’s really no way to get a “deal”.  High performing businesses will be valued accordingly.  The same can be said for struggling businesses.  If you buy an underperforming business, you might get a “good” price, but you will end up with an underperforming business.  If you buy a thriving business, you might pay a premium price, but you will get strong cash flow in exchange.

Ultimately, if you’re looking to buy or sell a business, there’s no reason to watch the economy and hope a shift will give you a better valuation multiple. It simply won’t happen. Instead, buy or sell a business when the timing is right for you on a personal level.