5 tips to increase your net income multiple
August 28, 2023 ⋅ 12 min read
If you're a small business owner, you know how vital it is to understand how your company is valued, especially if you’re preparing to sell.
One key metric that investors and buyers use to determine the worth of your business is the net income multiple — a financial ratio that measures your net income relative to the overall value of your company. A higher net income multiple means a more valuable business.
Improving your net income multiple isn't a back-breaking endeavor — it just requires a strategic approach. There are several highly effective ways to boost your ratio, and in turn, the value of your business.
In this article, we'll dive into 5 tips that will help you increase your net income multiple, ultimately enhancing the profitability of your business and making it more attractive to potential investors and buyers.
Whether you're looking to sell your company in the near future or just want to improve your financial standing, here’s how you can maximize your net income multiple.
What does multiple mean in valuation?
A multiple is a ratio used to value a company. It’s calculated by dividing a company's value by a certain accounting metric such as revenue, earnings, or cash flow.
Valuation multiples specifically are popular tools used by investors, analysts, and companies to assess a firm's financial performance and determine its equity value.
Multiples help investors and analysts quickly assess the value of a company and are widely used in business valuations.
Common valuation multiples
There are two main types of valuation multiples: equity multiples and enterprise value multiples.
Equity multiples are a type of valuation multiple that focuses on the company's equity or stock, often expressed in terms of price-to-earnings (P/E), price-to-sales ratio (P/S), or price-to-book (P/B) ratios.
The P/E ratio is a measure of a company's earnings per share relative to its share price. It indicates how much investors are willing to pay for each dollar of earnings generated by the company. A high P/E can suggest that a company is overvalued, while a low P/E may indicate undervaluation. P/E ratios are particularly useful for comparing companies within the same industry or sector, as they provide a measure of how much investors are willing to pay for a company's future earnings potential.
The P/S ratio compares a company's market capitalization to its revenues. This ratio is handy for evaluating businesses that are not yet profitable or have unstable earnings. A low P/S may indicate a company is undervalued relative to its revenue potential, while a high P/S could suggest an overvalued stock.
The P/B ratio measures a firm's market value relative to its book value, or a company's assets minus its liabilities. Investors use the P/B ratio to assess how much they would pay for a company's tangible assets if they were to purchase the entire business. A lower P/B can indicate an undervalued company, while a higher P/B may imply overvaluation.
These valuation multiples are forward-looking metrics, based on expectations of the future, so their accuracy depends on various factors such as market conditions, macroeconomic trends, and industry-specific developments. Equity multiples can also vary based on a company's size, capital structure, and growth prospects.
Enterprise value multiples
Enterprise value multiples are used to evaluate the overall value of a company, including debt and other liabilities.
These metrics are calculated by taking the enterprise value and dividing it by various financial measures such as earnings, revenue, or cash flow. They are used to evaluate a company's ability to generate cash flow and pay off its debts.
EV multiples are particularly useful when comparing companies that have different capital structures or levels of leverage. By comparing these multiples to industry standards or similar companies, investors can determine whether a company is overvalued, undervalued, or fairly valued.
The equity value multiple is used to measure the value of a company's outstanding shares of stock. It is calculated by multiplying the company's market value per share by the number of outstanding shares. This multiple is useful for investors looking to evaluate the overall value of a company.
The EBITDA multiple is used to evaluate the value of a company's earnings before interest, taxes, depreciation, and amortization. This multiple provides investors with an estimate of the cash flow generated by a company's operations.
Together, the EV/EBITDA multiple can be used to measure a company’s return on investment.
Valuation multiples often differ depending on the industry your company is operating in. For example, certain industries, such as technology, may require higher multiples due to higher growth rates and potential profitability. More mature industries like consumer staples may have lower multiples.
Increasing a company's valuation multiple is essential for businesses that want to attract investors or prepare for an acquisition. One way to increase your valuation multiple is to improve the company's financial performance.
For example, by increasing revenue or improving margins, a company can raise its EBITDA and, in turn, increase the EBITDA multiple. Another way to increase the multiple is to reduce financial risk by improving the company's balance sheet or reducing debt.
Multiples in business valuation are an essential tool for investors and analysts. They provide a quick and easy way to evaluate the value of a company, compare it with similar companies, and determine if it’s worth the investment.
EBIT versus EBITDA versus net income
These are three of the most commonly used metrics to determine valuation. Although they may seem similar, these measures have distinct differences that make them useful for different purposes.
Both EBIT and EBITDA start with net income before adding back interest and taxes.
EBIT, which stands for earnings before interest and taxes, is a measure of a company's operating performance. It is calculated by subtracting operating expenses from gross revenues.
The resulting number represents the net income generated by the company before interest and taxes are deducted. EBIT can be a useful metric for comparing the operating performance of different companies, regardless of their financing or tax arrangements.
EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is used to measure a company’s earnings potential before interest, taxes, and capital assets are deducted.
Capital assets are property like software, buildings, computer equipment, and machinery.
EBIT and EBITDA are both ways of measuring your company's profitability before taking into account certain expenses that can vary from business to business.
EBIT vs. EBITDA
EBIT and EBITDA can be useful for business owners who want to see how their company is performing on a more day-to-day basis, and how well they're managing their finances. These two metrics can be especially helpful when you're trying to compare your company's performance and profitability to that of other businesses within your industry.
However, EBITDA typically offers a more accurate, comprehensive picture of your company's profitability over a longer period, as it factors in depreciation and amortization expenses in addition to operating expenses.
This metric is often used by investors and analysts to evaluate the financial health of a company, as it provides a clearer picture of the company's underlying earnings power.
Net income is the bottom-line figure that reflects the profits earned by a company after all expenses, including taxes and interest payments, have been deducted from its revenues.
In other words, net income is a company’s revenue minus the cost of doing business, including taxes.
This measure is often used to calculate a company’s total earnings, which in turn can be used to calculate earnings per share.
What is a good valuation multiple?
What exactly makes a good valuation multiple? Is there potentially a magic number or ratio that signifies that a company is performing well and has a solid valuation?
A good valuation multiple should accurately reflect the value of the company, considering factors like the company's profitability, growth prospects, market share, and industry trends. It should also be comparable to similar companies in the industry.
Multiples that are too high or too low may not provide an accurate representation of the company's value and could lead to an overall incorrect valuation.
There are a few analysis methods to help ensure you have a good valuation multiple.
Comparable company analysis is a method of performing analysis using multiples and involves selecting companies that are similar to your own and comparing their valuation multiples to determine a fair value for your company. Precedent transaction analysis involves analyzing past transactions in the industry and comparing them to your company.
If you’re using net income multiple to determine the value of your business, there are a few ways to boost your multiple.
How to increase your net income multiple
It's no secret that companies with a strong capital structure tend to have higher multiples (and a better chance of selling at an ideal price), but what else can you do to improve your bottom line?
By taking an active role in the daily operations of your business, you can make strategic decisions that have a direct impact on your bottom line.
An involved owner is more likely to have a clear understanding of their target market and the competitive landscape. This knowledge can be used to inform marketing strategies, identify niche opportunities, and make smarter investment decisions that ultimately result in higher profits.
An owner who’s involved in the day-to-day operations of their business can help to ensure the business is running efficiently. Whether it's streamlining production processes or optimizing supply chain management, these improvements can pay off in the form of increased revenue, reduced expenses, and higher overall profitability.
Lowering key person risk
If your company is heavily reliant on one or two key employees, this can be a red flag for potential buyers. Why? There’s the potential for key figures to leave the company unexpectedly, or become ill or incapacitated, leaving your business in a lurch.
By reducing your reliance on any one individual, you can create a more reliable and robust organization that is better positioned to weather unexpected changes or challenges. To mitigate this risk, it's important to cross-train your staff and ensure that multiple team members are capable of handling critical functions.
Not only does this help protect your business, but it also shows potential buyers that the company is not overly reliant on any one individual.
Embracing recurring revenue
Recurring revenue tends to be more predictable and stable than one-time transactions. If your business relies heavily on one-time sales, it may be worth exploring ways to create more recurring revenue streams. This could include things like subscription services, maintenance contracts, or long-term service agreements.
Rather than relying on sporadic one-off transactions, recurring revenue allows you to establish long-term relationships with your customers. This translates into increased customer loyalty, retention, and more predictable cash flows, all of which contribute to higher net income multiples.
Another advantage of recurring revenue is that it enables better forecasting and planning for the future. With a predictable revenue stream, you can anticipate your cash flows, better allocate your resources, and make more informed business decisions.
If your business relies on a small number of customers for a large portion of your revenue, this can be seen as a risk to potential buyers. To mitigate this risk, it's important to diversify your customer base and ensure that no one customer accounts for too much of your revenue.
By doing this, you minimize your business's vulnerability to sudden shifts or downturns in the market. When you serve a wider range of customers, you open up new channels for revenue growth.
Working with a trusted advisor
Working with an advisor like Baton can be incredibly helpful when it comes to increasing your net income multiple. Baton helps business owners prepare for a sale by providing valuation services, strategic advice, and transactional support.
By partnering with an experienced advisor, you can position your business in the best possible light and ensure that you receive the highest possible multiple when it comes time to sell.
How do you calculate multiple net income?
The first step in calculating the multiple net income is to determine the expected growth rate. This can be done by looking at the growth rate of similar companies in the same industry, or by considering the expected level of growth based on the company's projections.
Once you have an idea of the expected growth rate, you can begin to compare your company's financial metrics — such as your income statement, cash flow, and free cash flow — to those of comparable companies. This is often done through a multiples analysis, which focuses on a specific financial metric such as the price-to-earnings (P/E) ratio.
In a multiples analysis, you would look at the P/E ratio of similar companies and compare it to the P/E ratio of the company you're evaluating. This can help you determine whether the company's equity value is undervalued or overvalued, and it can also help you identify more accurate predictors of their future growth potential.
You also want to consider interest expenses. This is the cost of borrowing money, and it can have a significant impact on a company's earnings. By subtracting the interest expense from the company's operating income, you can get a better idea of their true net income.
It’s also important to consider the enterprise value calculation. This takes into account the company's debt and cash balances, and it can provide a more accurate picture of their overall value.
Understanding and improving your net income multiple is crucial for increasing the overall value of your business. By maximizing your revenue and reducing expenses, focusing on operational efficiency, and investing in long-term growth strategies, you can improve your net income multiple, or any other valuation multiples you want to use.
Even if you’re not in a place where you’re ready to sell, regularly monitoring your financial statements and seeking the advice of advisors like Baton can help you stay on track and achieve your business goals. We can help you accurately determine your valuation and give you an action plan to improve it.
Increasing your net income multiple is not a one-time task, but rather an ongoing process that requires dedication, hard work, and a clear vision for your company's future success.