Industry Selection & Valuation Multiples

✨ In summary

The industry a business operates in is a key factor used to estimate business valuation and provide guidance to business owner clients. Industry classification enables financial advisors to use comparable benchmarks to estimate business valuation and compare key metrics to help owners understand how well their most important asset is performing

Selecting industry codes is a nuanced process. Use business tax returns, conversations with clients, and search or answer engines to help identify the most appropriate industry to reference in business valuation and benchmarking.

Industry NIACs Codes explained

Business industries are classified under the North American Industry Classification System (NAICS). The NAICS allows for detailed categorization of businesses into industries.

At its most detailed, NAICS uses six digit codes that signify the economic sector, subsector. Selecting a precise NAICS code is critical in business valuation and benchmarking exercises.

How industry selection impacts business valuation

Under Market Approaches to estimating business valuation, the industry NAICs code informs which valuation multiples can be applied to a business's earnings or revenue to estimate valuation.

What is a valuation multiple?

Valuation multiples are ratios between market value and financial benchmarks like earnings and revenue used to estimate business valuation.

When a businesses are sold, the transactions can be used as reference to estimate the value of comparable businesses within that industry
To make these reference transactions more practical during valuation exercises, ratios between market value and financial benchmarks like earnings and revenue are calculated and aggregated across these historic transactions
This creates a set of "valuation multiples" that are specific to each industry
In many industries, as a business grows in size, the valuation multiples they earn increase since they are seen as less risky
This size effect results in multiples being applied based thresholds of earnings and revenue within an industry

The two most common valuation multiples

The two most common valuation multiples are EBITDA and revenue multiples.

EBITDA Multiple: A ratio of the market value (Enterprise Value) to earnings
Revenue Multiple: A ratio of the market value (Enterprise Value) to revenue

For private small and mid-sized businesses (SMBs) that are well established, EBITDA valuation multiples tend to be relied on more heavily. For pre-revenue or very early-stage companies, revenue multiples become more relevant.

Identifying valuation multiples

Under Market Approach methods to estimating business value, an EBITDA or Revenue multiple is identified by:

Finding a set of the most comparable historic transactions to the business being valued
Comparing the business to that set to determine where they are similar and different
Estimating a reasonable multiple for the business being valued based on this comparison

Multiples selection exercises start by searching for the most comparable historic transactions to reference. Ideally this search yields 5 to 10 highly comparable transactions.

In general, comparability is determined with these criteria

Industry. Transactions within the same 6-digit NAICS industry code are considered more comparable while transactions within the same 2-digit NAICS sector code are considered less comparable.
Transaction recency. The more recent a transaction is, the stronger it serves as a reference point
Revenue, EBITDA, and margin of business that sold. Ideally the businesses in the transaction set have a revenue, earnings, and margin within a reasonable range of the business being valued. The closer these metrics are to the business being valued, the more comparable the transaction is considered.

Highly comparable transactions are hard to find for some businesses. In this case, a wider set of moderately comparable transactions can be used to examine the trends of an industry or sector more broadly.

It’s always important to compare market approach estimates of business value to income approaches as anchoring points since historic transactions data can be sparse or statistically noisy for some businesses types.

💡 RISR references a best in class historic transactions data covering 800 industries to find the most comparable transactions set for each business. A custom set reference set of historic transactions is built based on how recent the transaction is, the industry of the business, and how similar the business that sold is in terms of revenue, earnings, and margin. This ensures the most relevant EBITDA and revenue multiples are identified using the best data available.

Applying valuation multiples

To apply these multiples to estimate Enterprise Value, simply multiply them by the related financial benchmark

Example estimate of Enterprise Value using a 4x EBITDA Multiple: ($275k X 4.0) = $1,100,000
Example estimate of Enterprise Value using a 0.8 Revenue Multiple: ($1.2M X 0.8) = $960,000

In this case, the Market Approach using valuation multiples output a range of Enterprise Value between $960K and $1.1M. It's important to note that for the purposes of financial planning with business owners, these Enterprise Value estimates should be converted to Equity Value to better reflect what the value of the owner's equity.

Selecting NAICS Codes for valuation estimates

Selecting industry codes is a nuanced process since the system used to classify industry is robust and detailed.

Follow these practices to help clients identify the industry:

1) During discovery, use the business's website to understand its primary products and services

It's important to gather context around what the client's business does during discovery
Try to understand what product or service is driving the majority of its revenue

2) Use search and AI answer engines to identify which 6-digit NAICS codes may be relevant

Past descriptions of their primary products / services into tools like Google and ChatGPT
Ask which 6-digit NAICS code is most relevant and why

3) Reference business tax returns if available

An industry description generally appears on most federal business income tax returns
Note, many businesses misreport or leave the description too broad in tax forms
It's important that this be scrutinized during a valuation exercise to ensure precision
Review this code and compare it to your own references listed above with the client and their team

Frequently asked questions

How do I find a client’s industry classification?

Reference their website and use search and AI answer engines

Paste descriptions of their primary products / services and links to their website into tools like Google and ChatGPT
Ask which 6-digit NAICS code is most relevant and why

Reference business tax returns if available

An industry description generally appears on most federal business income tax returns
Note, many businesses misreport or leave the description too broad in tax forms
It's important that this be scrutinized during a valuation exercise to ensure precision
Review this code and compare it to your own references listed above with the client and their team

What if my client’s business seems to span multiple industries?

Identify the product or service that acts as the primary revenue driver and use that as reference to select the most related NAICS code. If revenue is split evenly, reference the product or service that aligns most with the business's growth strategy.

Where can I access benchmark and valuation multiples data once I have selected the industry code?

Benchmark data is a valuable resource to many parties in the financial ecosystem and is typically accessible by either paying a vendor that aggregates this data directly or adopting a business valuation tool that gives you access to similar data.

For most financial advisors, it's least cumbersome and more cost efficient to use a business valuation tool that provides access to these datasets than purchase and interpret them directly.

💡 RISR gives financial advisors access to industry valuation multiples for over 800 NAICS codes and automatically interprets which multiple is appropriate based on the size of the business.

Are wide differences in valuation estimates between Revenue and EBITDA Multiples common?

Each of the varying methods to estimate a business's value typically results in a different outputs. This is why aggregating multiple methods and removing outliers is an important part of any valuation exercise.

When comparing EBITDA and Revenue multiple estimates specifically, it is unfortunately common for there to be meaningful gaps in outputs

This is because the underlying transaction datasets often contain outlier transactions that swing valuation multiples up or down
This is especially true in industries that don't have a high volume of documented transactions
Since private businesses aren't required to report on these transactions publicly, the reliability of using a multiple is matter of whether quality data can be accessed

💡 RISR relies on a transaction dataset that has been adjusted for major outlier transactions and aggregates three best practice valuation methods to provide a balanced estimate of business value for financial advisors working with business owners.

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