TAS Tips: Valuation Fallacies

By Steve Michaels

April, 2003

The following is an ongoing segment featuring real life telemessaging industry transactions.  This month's installment comes in response to a question on how a business was valued.

I recently sent email to potential buyers of telemessaging businesses on the East coast, soliciting new business.  Here are some of the responses: "I see that the prices asked are about 14 times monthly revenue.  I have been paying a maximum of seven times.  Has there been a shift in selling prices?"  Or, "I am delighted to see that a telemessaging service can now command such incredible selling price.  When did this happen?  Why has the market changed so drastically?"

I don't know where the formula for pricing a telemessaging service as a multiple of monthly billing originated.  I believe it was devised during the cordboard era.  At that time labor, rental of the equipment and phone costs were comparatively similar, thus the only differential was the monthly billing.  For the average telecommunications company, this formula still works.  Here are two examples of how the formula may or may not apply.

Business A: This is a telemessaging service billing $25,000 per month.  It uses a paper-based telemessaging system.  Its labor as a percentage of total revenue is high because it is a paper-based system.  Therefore its net profit is on the average of 20%.  It is listed for seven times monthly billing or $175,000.  When you take 20 percent of $25,000 per month it equals $5,000 per month profit times 12 months, which is equal to $60,000 profit per year.  If you were to buy this business, it would take you 2.9 years to recoup your investment.  This is because $175,000 divided by $60,000 is equal to 2.9 times yearly net income, or seven times monthly billing.

Business B: This service is billing $110,000 per month utilizing an up-to-date paperless system with 16 positions.  Its net profit is 37 percent.  It is listed for 14 times monthly billing or $1.5 million.  When you take 37 percent of $110,000 per month it equals $40,700 per month profit times 12 months is equal to $488,400 profit per year.  If you were to buy this business, it would take you three years to recoup your investment.  This is because $1.5 million divided by $488,400 is equal to three yearly net or 14 times monthly billing.

The first scenario is an average business with an annual profit of $60,000 per year, with limited technology and an owner thoroughly tied to the daily operation of the business.  With the second scenario, there is management in place with supervisors that can oversee the labor, equipment that supports not only messaging but voice mail, email, and alpha paging and is Web-enabled.  For a larger bureau, there are greater economies of scale, so the percent of revenue spent on labor is lower.  Also, with the second business, you work less, make more money, and have a return on your investment in three years.  Which one would you prefer to buy?

Also other factors have to be taken into consideration with the pricing of a business.  These include location and service type, along with the old axiom of supply and demand.  If there are six aggressive buyers in an area all vying for the same business then the selling price will go up.  I have actually sold businesses for more than the asking price because certain criteria were being met.

In the telemessaging business, where the recurring revenue is factored into the price, the multiple is two to 3.5 times yearly EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), with 2.8 being the average.  This number depends upon factors such as location, management, size, type of accounts, longevity, equipment, and pricing structure, but most of all profitability.  All of these factors influence the pricing of the business.

When you look at mergers and acquisitions in this light, 14 times monthly billing is a much better deal than seven times, but our industry still has a times monthly billing mentality.  Executives must be open to seeing business valuations in a different light when it comes to larger, more profitable acquisitions.

In my evaluations, I still use the monthly billing scenario because it is what people in our industry understand and are used to.  But when I receive a premier listing like Business B, the "times monthly billing" formula is only part of the equation, so this is why a particular business sells for a higher multiple.

Steve Michaels and TAS Marketing have been serving the telemessaging industry in the mergers and acquisitions market for over 23 years with over 225 businesses sold.  He may be contacted at 800-369-6126 or tas@tasmarketing.com.

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