Industry Structure

When valuing a business, the primary consideration for most investors is the industry in which the business operates. This is usually the starting point of any valuation because multiples for similarly sized companies tend to cluster around a tight range in most industries. For example, multiples for retail businesses might be 4.0 to 5.0 times earnings before interest, taxes, depreciation, and amortization (EBITDA). In contrast, multiples for manufacturing businesses might be 6.0 to 7.0 times EBITDA.

Once you’ve determined the range of multiples for your industry, identify where in the industry your business is positioned. How do your company’s growth trends, margins, and profitability compare to others in your industry?

Here are the primary industry-related factors that can affect the value of your company:

• Barriers to Entry: How difficult would it be for a newcomer to enter your industry? The higher the barriers to entry, the higher the multiples generally are because the barriers limit new competitive threats. Buyers are more likely to be interested in an existing business if it’s more cost-effective to acquire it than replicate it from scratch – the classic buy vs. build decision. 
• Acquisition Activity: Have there been any recent acquisitions in your industry? The greater the acquisition activity in an industry, the more your business is likely worth. That’s because multiples tend to rise along with an increase in acquisitions. 
• Industry Trends: Is your industry seasonal, cyclical, or countercyclical? If your industry is cyclical, multiples will decrease along with declines in the overall economy. If your industry is countercyclical, businesses in your industry may become much more attractive when there’s a downturn in the overall economy due to a lack of other attractive investment opportunities. In a weak economy, for instance, discount retailers fare better than high-end brands, and fast food companies perform better than upscale restaurants. The appeal of countercyclical businesses can become especially apparent with private equity firms in a depressed economy if they have access to significant capital to invest when there are few alternative investments available.
• Industry Desirability: The multiples in an industry generally reflect the degree to which businesses in the industry are considered attractive investments. For example, the average EBITDA multiple for publicly traded firms in the airline industry tends to average around 8.0, whereas the average EBITDA multiple for the medical equipment industry has ranged from 20 to 25. Why? Because companies in the medical equipment industry offer the potential for higher rewards and are perceived as less risky than airlines. Travel is largely expendable; healthcare is not. Many businesses in the healthcare space are scalable; airlines are not.
• Industry Growth: The higher the growth potential of an industry, the higher the multiples generally are. If growth potential is limited, such as for retail businesses, multiples tend to be lower. Industries with strong growth potential, such as technology, are valued at high multiples. 
• Scalability: Scalability is the ability of a business to grow rapidly without increasing costs. The more scalable your business is, the more it will be worth. Industries with businesses that offer the ability to scale exponentially – software companies, for example – sell at high multiples. Industries that are less scalable – such as retailers – sell at much lower multiples. An industry that’s perceived as being more stable than the average industry reduces risk and drives up multiples, especially for financial buyers such as private equity firms. 
• Ability to Replicate: One of the most significant factors affecting your multiple is the degree to which your business can be replicated. This is the classic buy vs. build decision for acquirers. For example, if your business is difficult to replicate because you hold a number of patents, your company will sell at a much higher multiple than if your business is easy to mimic. If your business is easy to replicate, a buyer may believe it’s more cost-effective to build a business from scratch than acquire your business. 
• Regulations: Are there any regulatory threats on the horizon in your industry? Is regulation minimal or stable? Regulations can play to your advantage if they result in barriers to entry that may limit competition. Heavily regulated industries – such as petroleum and coal products manufacturing – are influenced more by external factors than most industries. Risk is higher as a result, and multiples are lower in many highly regulated industries than in other sectors.

When valuing a business, the primary consideration for most investors is the industry in which the business operates.