What Multiples Ignore

As shown above, multiples aren’t a perfect valuation method. In fact, multiples ignore several important variables, which are described below. 

The Effects of Capital Appreciation

In most cases, the majority of an entrepreneur’s net worth is in the form of capital appreciation in their business. Therefore, when calculating ROI, it’s critical to consider the effects of capital appreciation or growth in the value of the business. In most scenarios, the value of a business grows in relation to, but not directly proportional to, growth in its earnings. There may also be a gradual growth in the multiple, which is called “multiple expansion.” The idea is that the higher the EBITDA, the higher the multiple. Here are a few common scenarios that demonstrate the role of capital appreciation:

ROI and the Effects of Capital Appreciation on the Value of a BusinessAssuming a 5% annual growth rate in EBITDA and a 0.10 annual increase in multiple
Year	Annual Growth Rate in EBITDA	EBITDA	Multiple	Value of Business (EBITDA x Multiple)	ROI
1	5%	2,000,000	4.00	8,000,000	–
2	5%	2,100,000	4.10	8,610,000	8%
3	5%	2,205,000	4.20	9,261,000	16%
4	5%	2,315,250	4.30	9,955,575	24%
5	5%	2,431,013	4.40	10,696,455	34%
6	5%	2,552,563	4.50	11,486,534	44%
7	5%	2,680,191	4.60	12,328,880	54%
8	5%	2,814,202	4.70	13.226,744	65%
9	5%	2,954,912	4.80	14,183,572	77%
10	5%	3,102,656	4.90	15,203,017	90%

ROI and the Effects of Capital Appreciation on the Value of a Business Assuming a 20% annual growth rate in EBITDA
Year	Annual Growth Rate in EBITDA	EBITDA	Multiple	Value of Business	ROI
1	20%	2,000,000	4.00	8,000,000	–
2	20%	2,400,000	4.25	10,200,000	28%
3	20%	2,880,000	4.50	12,960,000	62%
4	20%	3,456,000	4.75	16,416,000	105%
5	20%	4,147,200	5.00	20,736,000	159%
6	20%	4,976,640	5.25	26,127,360	227%
7	20%	5,971,968	5.50	32,845,824	311%
8	20%	7,166,362	5.75	41,206,579	415%
9	20%	8,599,634	6.00	51,597,804	545%
10	20%	10,319,561	6.25	64,497,254	706%

Keep in mind that a 20% growth rate isn’t sustainable for long. But this illustrates the incredible effects of capital appreciation on ROI.

The following illustrates the impact of including cumulative EBITDA from the business when calculating ROI:

ROI and the Effects of Capital Appreciation on the Value of a Business Assuming a 5% growth rate in EBITDA
Year	Annual Growth Rate in EBITDA	EBITDA	Multiple	Value of Business	Plus Cumulative EBITDA	Total	ROI
1	5%	2,000,000	4.00	8,000,000	2,000,000	10,000,000	–
2	5%	2,100,000	4.10	8,610,000	4,100,000	12,710,000	59%
3	5%	2,205,000	4.20	9,261,000	6,305,000	15,566,000	95%
4	5%	2,315,250	4.30	9,955,575	8,620,250	18,575,825	132%
5	5%	2,431,013	4.40	10,696,455	11,051,263	21,747,720	172%
6	5%	2,552,563	4.50	11,486,534	13,603,826	25,090,360	214%
7	5%	2,680,191	4.60	12,328,880	16,284,017	28,612,896	258%
8	5%	2,814,201	4.70	13,226,744	19,098,218	32,324,963	304%
9	5%	2,954,911	4.80	14,183,572	22,053,129	36,236,702	353%
10	5%	3,102,656	4.90	15,203,017	25,155,785	40,358,799	404%

ROI and the Effects of Capital Appreciation on the Value of a Business Assuming a 20% growth rate in EBITDA
Year	Annual Growth Rate in EBITDA	EBITDA	Multiple	Value of Business	Plus Cumulative EBITDA	Total	ROI
1	20%	2,000,000	4.00	8,000,000	2,000,000	10,000,000	–
2	20%	2,400,000	4.25	10,200,000	4,400,000	14,600,000	83%
3	20%	2,880,000	4.50	12,960,000	7,280,000	20,240,000	153%
4	20%	3,456,000	4.75	16,416,000	10,736,000	27,152,000	239%
5	20%	4,147,200	5.00	20,736,000	14,883,200	35,619,200	345%
6	20%	4,976,640	5.25	26,127,360	19,859,840	45,987,200	475%
7	20%	5,971,968	5.50	32,845,824	25,831,808	58,677,632	633%
8	20%	7,166,362	5.75	41,206,582	32,998,170	74,204,752	828%
9	20%	8,599,634	6.00	51,597,804	41,597,804	93,195,608	1154%
10	20%	10,319,561	6.25	64,497,256	51,917,365	116,414,621	1355%

Unless you can project the future value of a business, you can’t accurately calculate the actual returns. You can estimate or project returns, but it’s just that – an estimate.

When attempting to calculate the returns of a business, it’s critical to consider the impact of growth on the value of a business. Obviously, this impact will be less for low-growth companies, such as retail, and greater for high-growth businesses, such as those in tech. Regardless, such a calculation will be a crude estimate, at best.

Calculating the potential return on businesses is inherently more difficult than calculating returns on other investments, such as real estate, due to the difficulty of projecting the future earnings, and therefore the value of a business. 

Multiples Ignore the Effects of Leverage 

Multiples don’t take into account the impact of leverage, or financing, on returns. Here are several scenarios that illustrate the impact of leverage on ROI:

The Impact of Leverage on ROI and Business ValueAssuming a 10-year note at 6% interest
	10% Down	25% Down	50% Down	All Cash
EBITDA	5,000,000	5,000,000	5,000,000	5,000,000
Price of Business	25,000,000	25,000,000	25,000,000	25,000,000
Down Payment	2,500,000	5,000,000	12,500,000	25,000,000
Annual Debt Service	2,997,554	2,664,492	1,665,308	0
Cash Flow After Debt Service	2,002,446	2,335,508	3,334,692	1,000,000
Cash-on-Cash Return	80%	47%	27%	25.00%

The Impact of Leverage on ROI and Business ValueAssuming a 10-year note @ 8% interest
	10% Down	25% Down	50% Down	All Cash
EBITDA	5,000,000	5,000,000	5,000,000	5,000,000
Price of Business	25,000,000	25,000,000	25,000,000	25,000,000
Down Payment	2,500,000	5,000,000	12,500,000	25,000,000
Annual Debt Service	3,275,845	2,911,862	1,819,914	0
Cash Flow After Debt Service	1,724,155	2,088,138	3,180,086	1,000,000
Cash-on-Cash Return	69%	42%	25%	25.00%

As the charts above illustrate:

• ROI increases as leverage increases.
• Returns are highly dependent on current interest rates.
• When interest rates rise, returns decrease.
• The greater the leverage, the higher the debt service, which increases risk.