According to well-known business valuation authority Dr. Shannon Pratt in his book The Market Approach to Valuing Businesses, “smaller companies in most industries tend to sell at lower multiples of most financial variables than larger companies in the same industry. This conclusion, reached from analysis of market data, is consistent with income approach (cost of capital) research, which shows that smaller companies have higher costs of capital (higher discount rates) than larger companies. Higher discount rates in the income approach should mean lower multiples in the market approach, and this relationship does, indeed, hold true.”
Pratt adds, “Middle Market companies with $2 to $3 million of earnings before interest, taxes, depreciation and amortization (EBITDA) are easier to sell and command higher pricing multiples on average than companies with $1 to 1.5 million in EBITDA. …Larger companies are less risky, and therefore, are priced in the market reflecting lower discount rates and higher market multiples. … The smaller the company, the higher the average cost of capital and the lower the average market valuation multiple.”
Pratt goes on to give examples to support his positions. While I agree with his opinions, I also believe that the presence and strength of intangible assets (such as brand, customer and supplier relationships, intellectual property) has a strong correlation to this size effect.
The Size Effect
This size effect continues across the entire spectrum of business size categories. Companies with less than $20 million revenue typically sell for lower price-to-earnings multiples than companies with $20 to $50 million revenue, and companies over $50 million revenue typically trade for still higher multiples. This relationship between price multiples and company size holds true for smaller businesses as well. Therefore, one must be sensitive to the range of revenue and earnings of comparable transactions relative to the subject company.
See our previous article, “Does Size Matters in Business Valuation?”
For further information on this subject or to discuss a business valuation need, contact Joe Orlando, ASA, at 503-925-5510 or firstname.lastname@example.org.