The 3x profit company valuation is a very simplified form of company valuation and means: profit multiplied by 3 = company value.
Basically, this type of assessment is based on two main components:
- Choice of profit metric
- Choice of multiplier
Choose profit metric
Choosing the right profit metric (e.g. net profit, EBITDA or operating profit) is a crucial factor. Each of these metrics has its own advantages and disadvantages. The industry, business model and financial structure are factors that can influence the selection of the profit metric.
Profit ratio depends on the industry
- Net profit is a common profit metric in many industries, especially traditional and established companies. This includes industries such as retail, consumer goods, manufacturing and healthcare. Net income takes into account all costs, including interest, taxes, depreciation and amortization, and provides a comprehensive insight into the company’s profitability.
- The EBITDA ratio (EBITDA: Earnings before Interest, Taxes, Depreciation and Amortization) is often used in industries where high depreciation and amortization costs as well as high capital investments are common. This includes industries such as technology, telecommunications, private equity and real estate development. EBITDA is often preferred because it provides greater insight into the company’s operating profitability, independent of financing costs and depreciation.
- Operating profit , also known as Earnings Before Interest and Taxes (EBIT), is commonly used in many industries. It provides a clear representation of profits before financing costs (interest) are taken into account. Operating profit is estimated in industries such as automobile manufacturing, aviation and hospitality.
Profit ratio depends on the business model
- Cost structure: The business model determines how costs are incurred in a company. A company with a high proportion of operating costs compared to financing costs may choose operating profit (EBIT) as a profit metric to evaluate pure operating profitability.
- Capital intensity: Companies that rely heavily on capital investment, such as manufacturers, choose EBITDA because it shows profitability before depreciation and amortization, thus better accounting for the impact of investments.
- Start-ups and growth-oriented companies: Start-ups and companies in growth phases prefer EBITDA because they often make large investments and the net profit may be distorted by high depreciation. EBITDA provides greater insight into operating profitability and growth potential.
- Taxes and legal aspects: The choice of profit ratio can also be influenced by tax considerations and legal regulations. Some countries have specific tax regulations that influence the choice of profit metric.
- Investor preferences: If the company relies on investors, the choice of profit metric may depend on the preferences and expectations of potential investors. Some investors may prefer net income, while others may prefer EBITDA to better understand financial performance.
- Long-term vs. Short-term view: Depending on whether the company plans for the long term or short term, the profit ratio can vary. Long-term investors might prefer net income, while short-term investors might use EBITDA for a short-term profitability assessment.
Profit ratio depends on the financial structure of the company
The financial structure of a company refers to the way it is financed and what its capital structure is.
- Leverage ratio: A company’s debt ratio, i.e. the ratio of debt to equity, can influence the choice of profit ratio. Companies with high levels of debt, where interest accounts for a significant portion of costs, should prefer EBITDA as it excludes interest and provides a better idea of operating profitability.
- Depreciation and amortization: for companies with significant depreciation and amortization costs, the net profit is negatively affected. In such cases, EBITDA can also be used to assess profitability excluding these costs.
- Equity Financing: Companies that are primarily funded by equity should favor net income because they are not as dependent on interest payments and tax breaks on debt.
Profit must be adjusted for extraordinary or non-recurring events.
Choice of multiplier
The multiplier (typically “3”) is applied to the earnings metric to calculate the company’s value. The following factors may cause an upward or downward deviation.
Impact of the industry
- Depending on the industry, there are different standards for evaluation. It is important to compare the multiplier with the industry average.
Assess risk factors
- Risk Assessment: Identify the specific risks your organization faces. These can be economic risks, competitive risks, legal risks or operational risks.
- Set risk level: Rate how high the risk is to your company on a scale from low to high. This can be subjective but should be based on thorough analysis.
- Multiplier adjustment: The higher the risk, the lower the multiplier should be. This means that with higher risks, your company will have a lower enterprise value.
- Growth Forecast: Estimate your company’s future growth potential. This can be based on historical growth rates, market analysis and strategic plans.
- Long-term and short-term view: Consider both long-term and short-term growth potential. Long-term growth can significantly increase value, while short-term forecasts are relevant to current decisions.
- Multiplier adjustment: The higher the expected growth, the higher the multiplier can be. A company with strong growth potential will have a higher value.
- Example: Suppose you have a company with a net profit of 500,000 euros and a multiplier of 3. If your company is considered riskier, you could lower the multiplier to 2.5. This results in a company value of 1,250,000 euros. However, if your business has significant growth potential and you take this into account, you could increase the multiplier to 3.5. This results in a company value of 1,750,000 euros.