Acq 5: Introduction

“Valuing a business is part art and part science.”

– Warren Buffett, American Investor and Philanthropist

Buyers buy businesses so they can receive a return on the investment (ROI) they make in the business. ROI is calculated by dividing the return by the amount of the investment. Here’s an example: 

$100,000 return/$1,000,000 investment = 10% return on investment 

In the real estate world, a capitalization rate is the rate of return a real estate investment generates. Typical cap rates for real estate range from 4% to 10%. This would correspond to an 10.0 to 25.0 multiple.

In the business world, ROI is the inverse of a multiple. If the multiple is 4.0, the ROI is 25%. For example:

$1 million EBITDA x 5.0 multiple = $5 million purchase price, or

$1 million EBITDA/$5 million purchase price = 20% ROI

Multiples are used in the business world because they’re simpler to calculate, and returns are significantly higher on businesses than other investments. Common multiples for most mid-sized businesses are 4 to 8 times EBITDA. This equates to a 12.5% to 25% ROI for the buyer, not taking into account the impact of any synergies. Because returns are higher, it’s easier to calculate a multiple than a cap rate.

For example, if a business generates $2 million in EBITDA, it’s much simpler to apply a 6 multiple than to calculate a cap rate of 16.66%. You can calculate the value of a business in your head when using a multiple, but when calculating a cap rate you’ll usually need to perform the calculation using a computer or calculator – or, in a pinch, the back of a napkin.

Calculating a multiple is quick and easy, enabling buyers to readily compare the potential returns on different investments. 

The return on investment is the inverse of the multiple.