Industry Selection & Valuation Multiples

Industry NAICS 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 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 and applying valuation multiples

Under Market Approach methods to estimating business value, an EBITDA or Revenue multiple is selected based on the reference industry and the size of the business.

Example EBITDA Multiple Chart

Multiples shown are fabricated for educational purposes only

Example Revenue Multiple Chart

Multiples shown are fabricated for educational purposes only

In the example above, if the client's business was earning $275k in normalized EBITDA and generating $1.2M in revenue the valuation multiples would be selected as follows:

• EBITDA Multiple: The client's earnings is within the 50th percentile of the industry since its earnings falls between $200K and $400K. An EBITDA multiple of 4.0X would be appropriate.
• Revenue Multiple: The client's revenue is within the 50th percentile of the industry since its revenue falls between $682k and $1.4M. Revenue multiple of 0.8X would be appropriate.

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

• Estimate of Enterprise Value using EBITDA Multiple: ($275k X 4.0) = $1,100,000
• Estimate of Enterprise Value using 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

• Paste 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