Hello, my name is Richard Claywell and this is litigation speaks. When a business valuation is performed, I have seen cases where the opposing expert will use Earnings Before Interest Taxes Depreciation Amortization (“EBITDA”). I want to talk today about what the pricing multiples mean.
The most popular method of determining a value in a business valuation is the discounted cash flow model. However, in the world of mergers and acquisitions, a pricing multiple is used instead of a discount or capitalization rate. The discount rate considers a multitude of factors to estimate a discount and capitalization rate. The discount and capitalization rate determine the present value of the future cash flows.
However, a pricing multiple is typically used in a business valuation using EBITDA. The question becomes, how are the pricing multiples determined? Typically the business valuator will make an assessment of 5, 6 or 7 as a reasonable multiple. But again how are the multiples determined?
The higher the capitalization rate the more risk associated with a business valuation and the lower the value. The lower the capitalization rate, the less risk associated with the business valuation and the higher the value.
As can be seen on the table below, an extremely high risk would be 100% and it would have a pricing multiple of 1. A low risk of 20% would have a pricing multiple of 5.
The business valuation expert should be able to provide evidence as to how the pricing multiple was determined to assign an appropriate pricing to the EBITDA calculation.
Business Valuation: Introduction to Pricing Multiples Deposition or Trial Questions for Attorneys
Question: Verify that the business valuation expert has used the correct pricing multiple.
Question: Ask the business valuation expert how the pricing multiple was selected.
Question: Ask the business valuation expert for the underlying analysis and supporting documents to justify the pricing multiple.