Margins & Multiples: How They Fit Together

How do operating margins affect the multiples that companies sell for?

ProfitChartCurveIn the landscape industry, we see a wide range of profit margins. In general, we see EBITDA margins of successful companies that range from around 7% to 20%. Many more companies are at the lower end of that range than the top. Of course, there are also many companies with lower margins and a few with higher ones.

There are many factors that may affect the multiple that a particular business may draw in an acquisition offer. Financial performance is definitely an important factor in determining business value and operating margins are one measure of financial performance that will play a role in evaluating value.

If a business has margins at the lower end of the range for its industry segment, it will usually be considered more risky than other companies in the sector. In other words, there is little risk of error. A further contraction of the margin may cause the acquisition target to fall short of projections and even flip to a loss. A buyer will often penalize an acquisition target with low margins by applying a risk premium to the discount rate. Translated to the language of multiples, that means a buyer will often pay a lower multiple for a business with lower margins.

Let’s take a look at the impact of high margins on multiples. We have already established that financial performance is a key determinant of business value. High operating margins are an indicator of high financial performance. Therefore higher margins should produce higher multiples, right?

It’s a little more complicated than that. Within a range, it is true that higher margins are likely to produce higher multiples. However, beyond a typical range of margins, there are new questions buyers are likely to ask:

How can this company generate margins that are so much higher than industry averages? What elements of revenue and expense contribute to the high operating margins? Are those margins sustainable after a change of ownership? Except in rare circumstances, a buyer is unlikely to give full value to extraordinary margins in valuing potential target.   In other words, they will apply a risk premium to the discount rate and, as a result, assign less value to margins significantly exceeding industry benchmarks.

Of course, the determination of the multiple any particular company will sell for is far more complicated than just looking at the target company’s margins.

We will be discussing multiples and margins at the Wealth Building Summit in Louisville, Kentucky, October 21. We hope to see you there. Register now as early   bird registration closes August 15. Register at Readers of this post will receive a $75 discount off the early bird price by using the promo code “LINKED75”. This offer expires August 15 and is not valid with any other promotion.

The Principium Group provides merger & acquisition, exit planning nd capital strategy services to lawn, landscape and there business services companies.  Contact us today if you are planning the sale or purchase  of a business in these areas.