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Several times recently I have been in discussions about company valuation and, in each case, the topic has moved to earnings multiples. If I have this sort of company, then it is worth/values on 1x, 3x, 10x whatever earnings, revenue, EBIT, etc. You know the conversations

Every time I hear this discussion I feel uncomfortable. It feels like the wrong end of the question.
Let me explain. On a discussion forum recently, someone asked, about valuing a niche logistics company for the drinks industry. This will do as an example. This is what I offered as my thoughts:

“I take the view that multiples of earnings is merely a surrogate “rule of thumb” for what the business is really worth to that buyer or a post justification of valuation when there has been a series of acquisitions in a market (well they paid 11 times earnings, so that is what it is worth).

The real driver of value to you is what is it worth to you.

For instance:

Is there a revenue stream (that is recurring and is tied to reasonably long term contracts) that provides an income greater than its costs? If there is then any buyer of the business can expect a revenue stream that provides income above the investment.

The next question is about pension (and other) liabilities, as there are plenty of organisations around whose valuation is negative until they sorts out their pensions (and other) issues. The next question is, what would it cost you to set up this logistics capability over the geographic area you are looking at?

This provides a maximum valuation for you ,as why buy someone else’s (possible mess) when you can start your own possible mess? – I joke but there is a serious comment in there.

Obviously, time might be an issue here as might be access to the skills. Are you buying because you believe you can access the market quicker than building the capability? If so, what will you do between now and the acquisition being completed? Is there a quicker way?

Secondly, ask what would it cost merely to contract these services. Again this provides a basis for the cost of the business as you can ask, why would I buy this business at a cost of (say) £1m and interest payments of £50,000, when I can access the service for less and not worry about the management of the service and having my capital tied up in a risk?

These two (what would it cost to build and what would it cost to just have it serviced?) provide a bracket around which you can value the company and think about the extra value you are trying to acquire through the acquisition, which we shall go on to…

It was described as a niche logistics company and I assume it refers to the niche of drinks distribution. You didn’t mention geographic area, so if you want to cover the whole of the country you may find a single company or need to buy up a range of companies that cover the whole range (and then dispose of overlapping, or surplus bits or area and infrastructure (like spare systems), vans, drivers, offices or routes).

How effective are their logistics skills. It’s a specialist area, so if there is someone (or a few) with a specific logistics planning and management that is really excellent (rather than just average) then that might be worth something as long as you can keep them. If you need to put a new management in, that will change the valuation.

What about their logistics assets? A fleet of new vans with modern planning and navigation and loading equipment will be worth far more than a tired set that relies on two drivers instead of one and breaks down regularly.

Is there any advantage in their existing customer base? I assume you are looking for channel access. What else are you buying? Are you buying access to their existing suppliers – those they are shipping for?

Are you buying access to their routes and customers to piggy back off their existing network, or are these all a distraction? What sort of capacity do you need and are you 10% or their capability or 200%? Either end will make a big difference, as will the rate of growth you plan.

Obviously, there are other aspects you might be thinking of. If you can find a distress sale of a business to get its assets and then use them in another area, that would change its valuation. So would buying a family business where the owner wants out. Also, is the value in real estate rather than the logistics operations?

I have come across organisations where their value and profit comes from the property business rather than what it is ostensibly trading as. To access the channel you need to access the land.

Basically I am asking you, what is it that you want in a logistics company that is worth something to you? What can you acquire it for by other means? What are you willing to pay for it? What liabilities are you also buying this way that you would not other ways?

So, in the reply, as you can see, the eventual earnings multiple is completely driven by what it is worth to the acquirer rather than some arbitrary pricing mechanism, or valuation multiple. Unless you are in a market where, by walking away someone else will buy it, (and you want to avoid that) then these are the things that should drive your valuation rather than the arbitrary market’s valuation.

As with all things, it’s a question of: what is it worth? not what does it cost? or what is it priced at?