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What are the Key Variables that affect Valuation: Understanding SME Valuations with Firebird Capital

Updated: Sep 18, 2023

The valuation a small or medium-sized enterprise (SME) can be a highly emotive and often mystifying process to many business owners.


In this article, we'll shed light on our valuation basis and look at some of the key variables that affect valuation such as: the size of profits, customer concentration, the level of recurring or repeat revenue, and the existence of a natural successor.


As you can imagine, there are a huge array of variables that affect valuation but this article will focus on the ones that Firebird believes have the biggest impact.


Valuation Basis - Earnings Multiple

Firebird Capital uses the earnings multiple methodology to value SMEs because of the ease with which it condenses considerations into a single, illuminating metric. To illustrate, it can provide:

  • Simplicity and Clarity: Earnings multiples provide a clear, concise view of a business's financial health, making it easy for investors and sellers to understand.

  • Comparability: These multiples enable straightforward comparisons with industry peers to ensure we are not over or under paying for a business.

  • Future Growth Assessment: Earnings multiples factor in growth prospects. Higher multiples often indicate anticipated earnings growth, while lower ones suggest more modest expectations.

  • Risk Evaluation: A higher multiple may signify lower perceived risk, while a lower multiple may imply higher risk.

In practice, this method involves evaluating a business's earnings or profits, often Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), and applying a multiple to determine its overall value. To illustrate:


Valuation = EBITDA x multiple


The rest of this article will focus on the variables that impact the multiple.

 

Size of Profits

The size of a company's profits is one of the primary determinants of its valuation and is Firebird’s starting point when it comes to deciding on the multiple applied to profits.


Businesses with higher profitability often command higher earnings multiples. To illustrate, business with profits at £500,000 or below tend to attract multiples in the 1x to 3x range. Whereas, businesses with profits of £1,000,000 or above can attract multiples in excess of 5x.


Firebird Capital conducts a thorough analysis of a company's historical financial performance to gauge the stability and growth potential of its profits.

 

Customer Concentration

Customer concentration refers to the extent to which a business relies on a small number of customers for its revenue.


High customer concentration creates more risk, as the loss of a major customer could significantly impact the company's financial stability. A diverse customer base can enhance the attractiveness of a business to investors.


Expect a lower earnings multiple and valuation where there is a high degree of customer concentration and a higher multiple where there is a diverse customer base.

 

Level of Recurring or Repeat Revenue

Recurring or repeat revenue is a valuable asset for any business, as it provides a predictable and stable income stream. Recurring revenue is revenue that is contracted. Repeat revenue is where customers repeatedly buy a product or service from a business.


Companies with a high level of recurring or repeat revenue often attract higher earnings multiples and valuations.


At Firebird Capital, we assess the proportion of revenue that is recurring or repeating and its impact on the company's valuation.

 

Natural Successor

A natural successor is an individual who can take over the management and leadership of the business seamlessly, preserving its value and continuity.


Firebird Capital considers the presence of a natural successor as a significant positive factor in valuation, as it reduces reliance on the retiring business owner. Firebird does not, however, consider the lack of a natural successor as a “deal breaker” as, although valuation will be impacted, it can work with current owners to identify, recruit and train a suitable candidate.

 

In conclusion, there are many factors that can affect valuation and it can be mystifying.


As experienced investors in SMES, Firebird Capital considers the key variables to be size of profits, customer concentration, recurring or repeat revenue, and the existence of a natural successor.


To help provide clarity, Firebird Capital has created a Business Valuation Tool to give a rough valuation range for SMEs. Please click here to use it.

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